tag:blogger.com,1999:blog-66169596423919886082018-03-19T06:14:36.677-07:00Calafia Beach PunditIn 2007 I retired as Chief Economist of Wamco, a manager of institutional fixed-income portfolios. I now enjoy keeping up on markets from my condo overlooking Calafia Beach (San Clemente). This site is not intended to provide trading or timing advice; I don't believe conditions in the market change very often. I am an investor, not a trader. Blogging is a source of self-discipline which helps me better understand the market and better manage my own portfolio.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.comBlogger3583125tag:blogger.com,1999:blog-6616959642391988608.post-30926974347157913582018-03-15T16:01:00.001-07:002018-03-15T16:01:13.982-07:0010 key charts updatedThe economy grew 2.5% last year, which is a bit stronger than its annualized rate of growth during the expansion which began in mid-2009, and there's evidence that growth picked up a bit over the course of the year, likely due to a significant increase in business and consumer confidence. Regardless, my reading of the market tea leaves suggests that the market's expectation for future growth is only slightly higher than what we've seen in the current expansion. Although the sharp cut to the corporate income tax rate has found its way into a substantial rise in stock prices (because reducing the tax rate means that the discounted value of future after-tax earnings translates into a one-time boost to current valuations), the market has yet to price in a substantial increase in future growth fueled by the increased investment and jobs creation that the tax cut was designed to achieve. (And to be sure, there is still no convincing evidence of a significant pickup in business investment.) The market is moving in an optimistic direction, of course, as witnessed by rising real and nominal yields, but we're still in the early innings.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-IC8-p7GCTm8/WqrsO9xXFuI/AAAAAAAAXoE/E0Xdh4FoOt8sq6VMCeaXoe5P4ep6ChZxACLcBGAs/s1600/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1142" height="240" src="https://4.bp.blogspot.com/-IC8-p7GCTm8/WqrsO9xXFuI/AAAAAAAAXoE/E0Xdh4FoOt8sq6VMCeaXoe5P4ep6ChZxACLcBGAs/s400/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" width="400" /></a></div><br />I've been posting updated versions of Chart #1 for many years now. It shows how unique the current business cycle expansion has been in the economic history of the US economy. From 1965 through 2007, the US economy grew at a trend rate of about 3.1% per year. It slipped below this trend during recessions, and exceeded the trend during boom times. But it invariably returned to trend given a few years. (Milton Friedman in 1964 wrote a paper about this, calling it the&nbsp;<a href="http://scottgrannis.blogspot.com/2009/06/thinking-about-gdp-growth.html">Plucking Model</a>.) The current expansion has been by far the weakest on record. Relative to its previous trend, the US economy is more than $3 trillion smaller, in 2009 dollars, than it might have been had things played out this time as they have before.<br /><br />What's the cause of this underperformance, especially considering that since late 2008 the Fed has massively expanded its balance sheet? My list of reasons lays the blame on two major factors: 1) an oppressive expansion of government, in the form of increased regulatory and tax burdens, and 2) a shell-shocked market that has only recently regained its former level of confidence in the wake of the Great Recession of 2008-9.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-sNkduYrHrnU/WqrtNGci5tI/AAAAAAAAXoI/sD-DZkTEJBg20J2jfcNLfN7J9087yvMbACLcBGAs/s1600/Michigan%2BConfidence.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1136" height="241" src="https://3.bp.blogspot.com/-sNkduYrHrnU/WqrtNGci5tI/AAAAAAAAXoI/sD-DZkTEJBg20J2jfcNLfN7J9087yvMbACLcBGAs/s400/Michigan%2BConfidence.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-mlS9e1odqZI/WqrtV5JyP7I/AAAAAAAAXoM/EP-nW9j9F8k-khHcJ8H6fExCIes1Wrf2QCLcBGAs/s1600/Small%2Bbusiness%2Boptimism.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1148" height="240" src="https://2.bp.blogspot.com/-mlS9e1odqZI/WqrtV5JyP7I/AAAAAAAAXoM/EP-nW9j9F8k-khHcJ8H6fExCIes1Wrf2QCLcBGAs/s400/Small%2Bbusiness%2Boptimism.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-LegXCDlCz0A/WqruOsblwuI/AAAAAAAAXoU/UdS7_hWGTSI_7HjnHoascDt_ch88cxCFgCLcBGAs/s1600/Labor%2BForce%2BGrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="353" data-original-width="579" height="242" src="https://4.bp.blogspot.com/-LegXCDlCz0A/WqruOsblwuI/AAAAAAAAXoU/UdS7_hWGTSI_7HjnHoascDt_ch88cxCFgCLcBGAs/s400/Labor%2BForce%2BGrowth.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div><div style="text-align: left;">Confidence has returned, but only in the past year or so, as shown in Charts #2 and #3. This may be the precursor of increased business investment—of which there is no sign yet—but it does explain the recent surge in the labor force, as shown in Chart #4. It's only very recently that we have seen a big increase in the number of people looking for work.&nbsp;</div><br /><div style="text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-pB3pH6MVdko/WqrvgFBOlQI/AAAAAAAAXog/_isng4mtJHEFG_p57LZOVXc7bQFhtk-JQCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://2.bp.blogspot.com/-pB3pH6MVdko/WqrvgFBOlQI/AAAAAAAAXog/_isng4mtJHEFG_p57LZOVXc7bQFhtk-JQCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><br />Thanks to TIPS (Treasury Inflation-Protected Securities), we have real-time knowledge of the market's expectation for risk-free, inflation-adjusted returns. (TIPS pay a real rate of interest in addition to whatever the inflation rate happens to be. The price of TIPS varies inversely with the market-determined level of the real yield on TIPS.) As the chart above shows, the level of real yields on TIPS tends to track the economy's trend real growth rate (I use trailing 2-yr annualized growth as a proxy for what the market perceives the current trend to be), much as common sense would suggest. When economic growth was booming in the late 1990s, TIPS paid a real rate of interest of about 4%, since they had to compete with the market's expectation for 4-5% real economic growth. But with the trend rate of growth having now slowed to just over 2%, the real rate of interest on TIPS is only modestly positive: 0.5% for the next 5 years, as of today. If the market thought the US economy were on track to deliver 3%+ rates of growth in the years ahead, I'm confident that the real yield on 5-yr TIPS would be in the neighborhood of 1-2%, if not higher. As it is, I think the market is currently priced to the expectation that real growth will average about 2.5% in the next few years. That's good, but nothing to write home about.<br /><br /><div style="text-align: center;">Chart #6</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-sOVGM0Jkan0/WqrwcFiaT_I/AAAAAAAAXoo/zJDNpYFMASQdzdXvqFEVBQN96ZeRDRqUwCLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1128" height="241" src="https://2.bp.blogspot.com/-sOVGM0Jkan0/WqrwcFiaT_I/AAAAAAAAXoo/zJDNpYFMASQdzdXvqFEVBQN96ZeRDRqUwCLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><br />Chart #6 compares the real yield on 5-yr TIPS (red line) with the ex-post real yield on the Fed funds rate, using the Fed's preferred measure of inflation, the PCE Core deflator. This is akin to viewing two points on the real yield curve: overnight rates and 5-yr rates. Using bond market math, the red line is the market's expectation for what the real Fed funds rate is going to average over the next 5 years. And of course, the real Fed funds rate (blue) is the rate that the Fed is actually targeting. As you can see, the market expects only a modest amount of tightening from the Fed in the years to come. That makes sense only if both the market and the Fed agree that the economy has limited upside growth potential. If the market thought the economy were set to grow at a 3%+ rate for the next several years, the market would immediately assume—and the Fed would probably agree—that there would be a a more aggressive series of rate hikes in the future, not just 3 or 4. Even still, when the Fed raises rates in response to stronger growth expectations, that is not a tightening, it's more a following action. To be really tight, the Fed would have to raise real rates to at least 3%, and the yield curve would have to flatten or invert.<br /><br /><div style="text-align: center;">Chart #7</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-Da2qUWiqYf0/WqrxkSeIFMI/AAAAAAAAXo0/QM_PMUtlUmcDax9UVkN-ryHrU5SeTJjHQCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://3.bp.blogspot.com/-Da2qUWiqYf0/WqrxkSeIFMI/AAAAAAAAXo0/QM_PMUtlUmcDax9UVkN-ryHrU5SeTJjHQCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a></div><br />Chart #7 compares the real and nominal yields on 5-yr Treasuries (red and blue lines) with the difference between the two (green line), which latter is the market's expectation of what the CPI will average over the next 5 years. With 5-yr inflation expectations today at 2.15%, the market is reasonably sure the Fed will be able to hit its 2% inflation target (on the core PCE deflator, which tends to run about 30 or 40 bps lower than the CPI). Looking ahead, the market sees pretty much the same amount of inflation that we have seen over the past few decades. The market is thus fairly confident that the Fed is not going to do much going forward, and whatever it does, the Fed is unlikely to be too tight or too easy. You may not agree with that assessment, but that's what the market tea leaves are saying.<br /><br /><div class="separator" style="clear: both; text-align: center;"></div><div style="text-align: center;">Chart #8</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-cKlSaKPiuY0/Wqry7VfmePI/AAAAAAAAXo8/J5m0kHhbE-YDdmA9Gym6UL-OC3bchVQXgCLcBGAs/s1600/Walls%2Bof%2Bworry.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1244" height="220" src="https://1.bp.blogspot.com/-cKlSaKPiuY0/Wqry7VfmePI/AAAAAAAAXo8/J5m0kHhbE-YDdmA9Gym6UL-OC3bchVQXgCLcBGAs/s400/Walls%2Bof%2Bworry.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div>Chat #8 shows how sensitive the stock market is to bouts of anxiety, as proxied by the ratio of the Vix "fear" index to the 10-yr Treasury yield. The latest market correction was triggered earlier this year by concerns that rising nominal yields might threaten economic growth, but that quickly faded, only to worry more recently that Trump's tariffs might spark a global trade war. Whatever the case, the market is not very worried these days, nor is it very optimistic.<br /><br /><div style="text-align: center;">Chart #9</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-R0olV3h3EaE/Wqr0ZNesRjI/AAAAAAAAXpE/Iu2ssmUqA242PmiS8MIaNYpjjmL2Ru5cACLcBGAs/s1600/2-yr%2BSwap%2BSpreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1128" height="251" src="https://1.bp.blogspot.com/-R0olV3h3EaE/Wqr0ZNesRjI/AAAAAAAAXpE/Iu2ssmUqA242PmiS8MIaNYpjjmL2Ru5cACLcBGAs/s400/2-yr%2BSwap%2BSpreads.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div><div style="text-align: center;">Chart #10</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-RUFizcefpmE/Wqr1VtwiA0I/AAAAAAAAXpI/56x6Bk7xibMAs4MJqCmmxeiYd3nOI9NoQCLcBGAs/s1600/CDS%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1260" height="216" src="https://2.bp.blogspot.com/-RUFizcefpmE/Wqr1VtwiA0I/AAAAAAAAXpI/56x6Bk7xibMAs4MJqCmmxeiYd3nOI9NoQCLcBGAs/s400/CDS%2Bspreads.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div>A general lack of concern about the economy's health is evident in Charts #9 and #10. Swap spreads—an excellent coincident and leading indicator of economic and financial market health—are up a bit of late, but still within what might be considered a "normal" range. The swap market is reflecting a relative abundance of liquidity and little if any concerns about systemic risk. Credit Default Spreads—highly liquid and coincident indicators of the market's perception of credit risk—are also up a bit of late, but still relatively low.<br /><br />As I noted last October, and as has proven recently to be the case, rising growth expectations would almost surely result in an unexpected rise in real and nominal interest rates. Higher-than-expected rates would depress bond prices, and, in similar fashion, could depress the market's PE ratio (which is the inverse of the earnings yield on equities, and thus similar to a bond price), thus limiting further gains in equity prices to a rate that is somewhat less than the increase in earnings. The days of booming equity markets are fading, but there is still decent upside if and when the market begins pricing in faster growth and the business community follows through with increased investment and faster jobs creation. Meanwhile, there is no obvious reason to worry about a recession or a major stock market correction.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com4tag:blogger.com,1999:blog-6616959642391988608.post-20338263546258713442018-03-15T11:15:00.000-07:002018-03-15T11:15:02.662-07:00Thanks and congratulations, Larry!My career as an economist began in 1980, the day I stumbled upon John Rutledge's CEI Forecasting Conference on the campus of Claremont McKenna College. At the time, I was in the midst of the MBA program at Claremont Graduate University, having previously received a BA in Philosophy at Pomona College (economics, I would learn, draws heavily from philosophy and business). Larry Kudlow happened to be the key speaker at the conference. He spoke of inflation, gold, the dollar, and economic growth, and all those things strongly resonated with me, as I had recently returned from four years in Argentina (1975-1979). I remember thinking there was nothing in the world that could be more exciting than to follow in his footsteps. Thanks, Larry, for being such an inspiration.<br /><br />While living in Argentina I had the "privilege" of surviving inflation that raged at well over 100% per year, suffering gargantuan swings in the value of the peso (which lost over 95% of its value), and witnessing the military takeover of the failed government of Peron's widow, Isabel. Following macro-economic variables daily in Argentina was critical to survival, and in Larry I saw that my experiences in Argentina could serve as the foundation for an economics profession in the U.S. One year after seeing Larry speak, I was working for John Rutledge and meeting the likes of Larry, Art Laffer, Jude Wanniski, Bob Mundell, David Malpass, and Steve Moore. I grew up on the supply- and monetarist-side of the economics profession, because I became convinced that those disciplines held the key to best understanding how economies and markets work. Politically I'm a libertarian, because I'm convinced that governments and bureaucrats can never be as effective and efficient as free markets, and more government necessarily means less individual freedom, and that can never be a good thing.<br /><br />Larry was the first economist who inspired me, and we've been close in our thinking ever since (he even reads this blog). Although we haven't always agreed on everything, and neither of us can claim to have forecasted the Great Recession, we share the most important values: a strong and stable dollar (which implies low and stable inflation), strong and steady economic growth, limited government, rule of law, and free markets (which imply free trade). We both know that any country that embraces those values is bound to be a place of opportunity and prosperity. Larry's whole life has prepared him for a position in which he can help influence the policies that will make the U.S. strong and prosperous. Congratulations, Larry, you've made it.<br /><br />So naturally, everyone wants to know why Trump picked Larry, and why Larry chose to accept, since they have diametrically opposing views on trade and tariffs.<br /><br />The best explanation that comes to mind is that Trump has persuaded Larry that higher tariffs are 1) temporary and 2) a tool with which to pressure China into opening its markets to more foreign goods and services and respecting intellectual property rights. A minor transgression, if you will, that will eventually yield a greater payoff. If nothing else, Larry's presence at the NEC will be a critical offset to Peter Navarro, and a voice of reason and experience that may keep Trump from wandering into "left" field. That Trump chose Larry, knowing his opposition to tariffs, speaks well to Trump's judgment.<br /><br />Larry is a good man, an excellent economist, and a seasoned persuader. He is a great choice for director of the White House National Economic Council.<br /><br />For more, today's WSJ has two excellent articles which faithfully round out the person that is Larry Kudlow: <a href="https://www.wsj.com/articles/kudlow-into-the-breach-1521068506">here</a>, and <a href="https://www.wsj.com/articles/what-to-expect-from-national-economic-council-under-lawrence-kudlow-1521121093?mod=cx_picks&amp;cx_navSource=cx_picks&amp;cx_tag=poptarget&amp;cx_artPos=1#cxrecs_s">here</a>.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com8tag:blogger.com,1999:blog-6616959642391988608.post-25627238835553939812018-03-09T08:20:00.000-08:002018-03-09T08:20:44.088-08:00Early signs of a stronger jobs marketFebruary private sector job gains were substantially stronger than expected (287K vs. 205K), and prior months were revised higher. This is good news, but we are still in the early innings of what is likely to be a more powerful and sustained improvement in the jobs market. That's what I anticipated in my <a href="http://scottgrannis.blogspot.com/2017/12/predictions-for-2018.html">2018 predictions</a>: <i>waiting for GDP</i>. For the past few months I've argued that the market has priced in the one-time impact of a significant reduction in the corporate income tax rate, but the market has still not yet priced in the expectation of a significant boost to future GDP growth. "Waiting for GDP" is still the meme to watch for, and today's jobs number is the first sign that this meme may in fact be realized, but it's too early to know for sure. Of course, once it's clear that GDP growth could exceed 3% or so on a sustained basis, the stock market will be making new highs. For now, we can be hopeful that this will be the case.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-Se43ciWYTok/WqKs89MOnJI/AAAAAAAAXnY/ZfoVhd6s_Y8llY99m7vvgULV3XymlhmqgCLcBGAs/s1600/Monthly%2BChange%2B97-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1150" height="236" src="https://1.bp.blogspot.com/-Se43ciWYTok/WqKs89MOnJI/AAAAAAAAXnY/ZfoVhd6s_Y8llY99m7vvgULV3XymlhmqgCLcBGAs/s400/Monthly%2BChange%2B97-.jpg" width="400" /></a></div><br />Chart #1 shows the monthly change in private sector jobs from an historical perspective. February was strong, but it's hardly a unique occurrence; we've seen numbers like this from time to time and in the end they have proved transitory, not the start of something big. We'll need to see more such numbers (e.g., job gains of at least 300K per month) before it's clear that the economy has kicked into a higher gear.<br /><br /><div style="text-align: center;">Chart #2</div><div style="text-align: center;">&nbsp;<a href="https://2.bp.blogspot.com/-pO8yrMkjCVM/WqKtP1YcotI/AAAAAAAAXng/QGe9NAKL0HMSfKBIumZo9VHAOgKyYgsKACLcBGAs/s1600/Private%2BSector%2BJobs%2BGrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="684" data-original-width="1130" height="241" src="https://2.bp.blogspot.com/-pO8yrMkjCVM/WqKtP1YcotI/AAAAAAAAXng/QGe9NAKL0HMSfKBIumZo9VHAOgKyYgsKACLcBGAs/s400/Private%2BSector%2BJobs%2BGrowth.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #2 shows the 6- and 12-month annualized rate of change of private sector jobs growth. You can't come to any conclusions with just one strong number, you've got to see a series of strong numbers. Jobs data are notoriously volatile and subject to significant changes after the fact. So far, all we've see in recent months is that private sector jobs growth has risen from 1.7% to just under 2%. Hold the applause until jobs growth exceeds 2% by a substantial margin—we're not there yet.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-h5-9O0N7PJA/WqKtHi_8s9I/AAAAAAAAXnc/dJqtZR2UNRAUFZEDXt_fGqq2huEV1jnAgCLcBGAs/s1600/Labor%2BForce%2BGrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="353" data-original-width="579" height="242" src="https://1.bp.blogspot.com/-h5-9O0N7PJA/WqKtHi_8s9I/AAAAAAAAXnc/dJqtZR2UNRAUFZEDXt_fGqq2huEV1jnAgCLcBGAs/s400/Labor%2BForce%2BGrowth.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: left;">Since the unemployment rate is quite low—4.1%—we need to see a sustained increase in the labor force participation rate. Many millions of workers have "dropped out" of the labor force, and they will have to elect to return if the jobs market is to generate more than 300K new jobs every month. Fortunately, today's jobs number suggests this process may be beginning. Labor force growth has picked up significantly, as Chart #3 shows.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-z7wC9d7O8Bk/WqKyzyrSP2I/AAAAAAAAXn0/-iaZrHv_oWI-omlXEXL3T_yQpHSuBdf_QCLcBGAs/s1600/Screen%2BShot%2B2018-03-09%2Bat%2B9.13.30%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1004" data-original-width="1438" height="278" src="https://2.bp.blogspot.com/-z7wC9d7O8Bk/WqKyzyrSP2I/AAAAAAAAXn0/-iaZrHv_oWI-omlXEXL3T_yQpHSuBdf_QCLcBGAs/s400/Screen%2BShot%2B2018-03-09%2Bat%2B9.13.30%2BAM.png" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">But it's still early, since the labor force participation rate (the percentage of people eligible to work who are working or looking for work) currently is only 63%, and the rate hasn't changed on balance for the past several years. We'll need to see it increase to 64% or more. Chart #4 gives you an idea of how low it has been (it started to decline in early 2009) and where it could go in the future if optimism returns in a serious fashion—as happened in the boom years of the late 1980s.</div><br /><br />Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com6tag:blogger.com,1999:blog-6616959642391988608.post-44996122669374272692018-03-08T12:41:00.000-08:002018-03-08T21:10:49.615-08:00Household net worth hits $100 trillionToday the Fed released its quarterly estimate of household net worth. Things just keep getting better and better. Household net worth as of the end of last year was almost $99 trillion, having risen $7.1 trillion over the past year (+7.8%). As in recent years, gains have come mostly from financial assets (up $27.6 trillion since late 2007), plus real estate (up $2.8 trillion since the pre-Recession peak of 2006), offset by only a $1 trillion increase in debt (total liabilities rose from a Recession peak of $14.6 trillion in 2008 to $15.6 trillion at the end of 2017). Further details in the charts below:<br /><div><br /></div><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-Ux7idGsw-Yg/WqGb0mnTH8I/AAAAAAAAXmw/pdf0LcxJF68nx95LLs969L7aZShPtcBmACLcBGAs/s1600/Households%2BBalance%2BSheet.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1286" height="220" src="https://3.bp.blogspot.com/-Ux7idGsw-Yg/WqGb0mnTH8I/AAAAAAAAXmw/pdf0LcxJF68nx95LLs969L7aZShPtcBmACLcBGAs/s400/Households%2BBalance%2BSheet.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div>Chart #1 summarizes the evolution of household net worth. <br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-DvQnHx92Ndc/WqGb_fjUiUI/AAAAAAAAXm0/NgR2iN2pugwsR1YPS4Tb6kEvmU5Jba1FwCLcBGAs/s1600/Real%2Bnet%2Bworth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="674" data-original-width="1134" height="240" src="https://2.bp.blogspot.com/-DvQnHx92Ndc/WqGb_fjUiUI/AAAAAAAAXm0/NgR2iN2pugwsR1YPS4Tb6kEvmU5Jba1FwCLcBGAs/s400/Real%2Bnet%2Bworth.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #2 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 65 years. I note also that recent levels of net worth do not appear to have diverged at all from long-term trends. That wasn't the case in 2007 however, when stocks were in what we now know was a valuation "bubble."</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-sbVMvMvhyOA/WqGcGTMrD0I/AAAAAAAAXm4/qJwNKEzZoqQ981KpU5COUL8kzSUPRMfcACLcBGAs/s1600/Real%2Bper%2Bcap%2Bnet%2Bworth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="676" data-original-width="1150" height="233" src="https://1.bp.blogspot.com/-sbVMvMvhyOA/WqGcGTMrD0I/AAAAAAAAXm4/qJwNKEzZoqQ981KpU5COUL8kzSUPRMfcACLcBGAs/s400/Real%2Bper%2Bcap%2Bnet%2Bworth.jpg" width="400" /></a></div><br />Chart #3 shows real net worth per capita. The average person in the U.S. today is worth just over $300,000, and that figure has been increasing by about 2.3% per year for the past 67 years. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce almost $20 trillion of income per year.<br /><div><br /><div style="text-align: center;">Chart #4</div><div><a href="https://3.bp.blogspot.com/-C0T_buZ7lJ4/WqGcZxRkwKI/AAAAAAAAXnA/efkW_ejgo8YbzGgovRbagYRqNPbU5jOZwCLcBGAs/s1600/Household%2Bleverage.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="676" data-original-width="1140" height="236" src="https://3.bp.blogspot.com/-C0T_buZ7lJ4/WqGcZxRkwKI/AAAAAAAAXnA/efkW_ejgo8YbzGgovRbagYRqNPbU5jOZwCLcBGAs/s400/Household%2Bleverage.jpg" width="400" /></a></div></div><div><br /></div>Chart #4 shows that households have been extremely prudent in managing their financial affairs since the Great Recession. Household leverage (total debt as a % of total assets) has declined by one-third since its Q1/09 high. Leverage is now back to the levels which prevailed during the boom times of the mid-80s and 90s. Unfortunately, while households were busy strengthening their finances, the federal government was doing just the opposite: the burden of federal debt more than doubled from June '08 to December '17 (i.e., federal debt owed to the public rose from 35% of GDP to 75% of GDP).Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com7tag:blogger.com,1999:blog-6616959642391988608.post-6432957910502538502018-03-01T12:17:00.001-08:002018-03-01T12:17:27.619-08:00Manufacturing sector ramping stronglyEarlier this year I noted that the manufacturing sector was<a href="http://scottgrannis.blogspot.com/2018/01/manufacturing-is-off-to-strong-start.html"> off to a strong start</a>. Today's ISM releases for February only underscore that point. Things look so good (if you ignore Trump's tariffs) that I'm compelled to post these impressive charts. They strongly suggest that with his tariffs, Trump could be about to snatch defeat from the jaws of victory.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-9YLrdpnpmc4/WphcImEO-fI/AAAAAAAAXl0/WljjzwiLUtQY6kte9YgMyi7OBi-aSh5PACLcBGAs/s1600/NAPM%2Bvs%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1226" height="232" src="https://2.bp.blogspot.com/-9YLrdpnpmc4/WphcImEO-fI/AAAAAAAAXl0/WljjzwiLUtQY6kte9YgMyi7OBi-aSh5PACLcBGAs/s400/NAPM%2Bvs%2BGDP.jpg" width="400" /></a></div><br />There's been a decent correlation between the ISM manufacturing index and the health of the overall economy. February's number strongly suggests that Q1/18 growth is going to exceed current forecasts of 3-3.5% (according to the NY and Atlanta Fed's models, respectively).<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-kKJHctXnq2U/WphcPRIf8II/AAAAAAAAXl4/HPBJOe9T_Qccy02C72iVHcuaHynWr-woQCLcBGAs/s1600/NAPM%2BExports.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1110" height="245" src="https://4.bp.blogspot.com/-kKJHctXnq2U/WphcPRIf8II/AAAAAAAAXl4/HPBJOe9T_Qccy02C72iVHcuaHynWr-woQCLcBGAs/s400/NAPM%2BExports.jpg" width="400" /></a></div><br />Export orders are coming in very strong, which suggests that overseas economies are doing very well.<br /><br /><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-zxR-d74chsY/Wphcsg2PiqI/AAAAAAAAXmA/KgqMc1IXWJQRIdfanoKlXvhPsucDfVjfACLcBGAs/s1600/ISM%2BEmployment.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1122" height="242" src="https://3.bp.blogspot.com/-zxR-d74chsY/Wphcsg2PiqI/AAAAAAAAXmA/KgqMc1IXWJQRIdfanoKlXvhPsucDfVjfACLcBGAs/s400/ISM%2BEmployment.jpg" width="400" /></a></div><br />The relatively strong employment reading suggests that manufacturers are optimistic about their ability to expand.<br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-_hSeW7lXjlQ/Wphc3LvC38I/AAAAAAAAXmI/-SBpLsjSvgUWvY7juhItAuNxRPLJ5Ku2wCLcBGAs/s1600/US%2Bvs%2BEurozone%2BMan.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1126" height="241" src="https://4.bp.blogspot.com/-_hSeW7lXjlQ/Wphc3LvC38I/AAAAAAAAXmI/-SBpLsjSvgUWvY7juhItAuNxRPLJ5Ku2wCLcBGAs/s400/US%2Bvs%2BEurozone%2BMan.jpg" width="400" /></a></div><br />This is a lovely picture of a US/Eurozone synchronized manufacturing recovery. The global economy is firing on all cylinders; why would anyone want to mess with this?Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com8tag:blogger.com,1999:blog-6616959642391988608.post-53432026805522648432018-03-01T11:53:00.001-08:002018-03-02T08:20:53.566-08:00Trump's tariffs are cause for concernEvery economist worth his salt knows that tariffs are just plain bad policy. They supposedly "help" domestic producers (subsidize would be a better word), but they hurt just about everyone else. Making steel and aluminum more expensive for US consumers may temporarily help US workers who produce the stuff, but it undeniably harms all US consumers of the stuff. Ultimately there will very likely be many more jobs lost in the industries that use steel and aluminum than jobs "protected" in the steel and aluminum producing industries.<br /><br />And of course the worst thing would be if this is the first salvo in what could degenerate into a global trade war. That is the stuff of nightmares, and it's the sort of thing that can cause global depressions.<br /><br />Trump has always been partial to tariffs, and has been roundly and justifiably criticized for it. I was hopeful that it was just bluster, and that when push came to shove the smart people surrounding him would persuade him to desist. That seemed to work for over a year, but apparently it's no longer the case.<br /><br />Will he really do something so stupid? Stock markets are correct to sell off on the news. We can only hope that a hue and cry and weak stock markets convince Trump to back off. It's hard to believe he could pull such a stupid, dumb idea out of his hat just when the economy is about to ramp up as a result of all the good things he has done.<br /><br />UPDATE: Mark Perry has an excellent <a href="http://www.aei.org/publication/president-trumps-predecessors-learned-about-steel-tariffs-the-hard-way/">post</a> which demonstrates that the losses from tariffs always exceed the gains, and by a huge margin.<br /><br />UPDATE: Here's how the market is taking the tariff threat as of 8am Pacific, March 2nd. It's a genuine threat, to be sure, but not catastrophic. Trump is getting TONS of pushback, which may persuade him to back off.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-PH0slRzduFA/Wpl5yJh52YI/AAAAAAAAXmc/99D7vG5h1-gDl64hgbg4RPPxxafNFOlYgCLcBGAs/s1600/Walls%2Bof%2Bworry.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1244" height="220" src="https://4.bp.blogspot.com/-PH0slRzduFA/Wpl5yJh52YI/AAAAAAAAXmc/99D7vG5h1-gDl64hgbg4RPPxxafNFOlYgCLcBGAs/s400/Walls%2Bof%2Bworry.jpg" width="400" /></a></div><br />Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com2tag:blogger.com,1999:blog-6616959642391988608.post-88942183554363468362018-02-27T15:00:00.001-08:002018-02-27T15:00:37.457-08:00The outlook is still healthyThe world hasn't changed much in the past month, and neither has my outlook, which remains bullish on the economy and moderately bullish on stocks. Trump's tax reform is a big deal, because it is designed to stimulate investment directly, by increasing the after-tax value of corporate profits. More investment means more jobs, more productivity, and higher living standards for all. This type of tax reform needn't explode the deficit, because it will greatly expand the tax base by 1) encouraging more investment, 2) making tax evasion less profitable, 3) attracting overseas investment, 4) increasing the number of jobs, and 5) increasing real wages. In the end, a significant boost to growth would likely dominate concerns over any near-term increase in the federal deficit. (I will refrain from projecting deficits at this point, however, since there are simply too many variables involved, especially real GDP growth and the growth of entitlement spending, with the former being more important than the latter.)<br /><br />Since stronger economic growth dictates higher real interest rates, any concerns about higher interest rates negatively impacting the economy are premature. Higher interest rates are the natural result of stronger growth, as FOMC members have taken pains to explain. In any event, real yields are not even close to levels which might threaten growth. Moreover, there are still plenty of excess bank reserves in the system, and key indicators of market liquidity (e.g., swap and credit spreads) confirm that financial conditions are healthy. By all indications, the Fed is moving short-term rates higher in a healthy and non-threatening fashion.<br />&nbsp; <br />Since early last year, there have been some profound changes in the US economy which augur well for the future. Perhaps the most important is increased confidence, which has largely replaced the risk-aversion that characterized most of the current recovery.<br /><br />As I've argued many times over the years, the Fed's Quantitative Easing was a necessary response to the &nbsp;risk aversion that led to the world's almost insatiable demand for money and safety in the wake of the Great Recession. QE is no longer necessary now, so it is appropriate for the Fed to wind down QE by raising short-term interest rates and draining excess bank reserves. If the Fed weren't taking these steps, that would a source of concern, since they would be allowing a buildup of excess money which would inevitably find its way into much higher and unwanted inflation. To date, market-based measures of inflation expectations remain within reasonable levels, and that in turn confirms that the Fed is acting appropriately.<br /><br />Here's a review of the vital signs of the economy and financial markets (all charts include latest data available as of time of posting):<br /><br /><div style="text-align: center;">Chart #1</div><a href="https://1.bp.blogspot.com/--PciVVj1Z8o/WpS-Tk8GAVI/AAAAAAAAXjI/qtR7-J2dwY8um764qoH8w4oaXXlxcOUowCLcBGAs/s1600/M2%2B2007-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="680" data-original-width="1116" height="242" src="https://1.bp.blogspot.com/--PciVVj1Z8o/WpS-Tk8GAVI/AAAAAAAAXjI/qtR7-J2dwY8um764qoH8w4oaXXlxcOUowCLcBGAs/s400/M2%2B2007-.jpg" width="400" /></a><br /><br />Chart #1 shows the level of the M2 money supply, which is widely considered to be the best measure of the amount of cash and readily-spendable cash equivalents in the economy (M2 consists of savings deposits, retail checking accounts, currency in circulation, small time deposits, and retail money market funds). M2 has been growing on average by 6-7% per year since 1960, and the most recent decade is no different, despite the Fed's alleged "money printing." As I've argued previously, QE was not about printing money, it was about <a href="http://scottgrannis.blogspot.com/2013/03/the-fed-is-not-printing-money.html">transmogrifying notes and bonds into T-bill equivalents</a> (aka bank reserves). Note, however, the recent slowdown in M2 growth; what looks like a moderate shortfall relative to trend is actually one of the most significant monetary developments in many years, as I explain below.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-JxXVfDGjiEE/WpTAteF_QWI/AAAAAAAAXjo/iVAOTRxXvHEEnSFv_ZmpdNXaaUXpm-ULwCLcBGAs/s1600/Savings%2Bdeposits%2B08-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1106" height="245" src="https://4.bp.blogspot.com/-JxXVfDGjiEE/WpTAteF_QWI/AAAAAAAAXjo/iVAOTRxXvHEEnSFv_ZmpdNXaaUXpm-ULwCLcBGAs/s400/Savings%2Bdeposits%2B08-.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #3</div><a href="https://3.bp.blogspot.com/-BGTftVzh8HY/WpS9AwzBXDI/AAAAAAAAXio/3Yyok0DVFgg_-NVDZAqlm8KCwijFykWdACLcBGAs/s1600/Excess%2Breserves.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="716" data-original-width="1128" height="253" src="https://3.bp.blogspot.com/-BGTftVzh8HY/WpS9AwzBXDI/AAAAAAAAXio/3Yyok0DVFgg_-NVDZAqlm8KCwijFykWdACLcBGAs/s400/Excess%2Breserves.jpg" width="400" /></a><br /><br />Chart #2 shows the level of bank savings deposits, whose growth was rather spectacular in the years following the Great Recession. Bank savings deposits represented about 50% of M2 in late 2008, and they now represent 66%, which is the highest level in recorded history. A terrified world deposited trillions of dollars in bank savings accounts, despite the fact that they paid almost no interest. Banks effectively used this huge inflow of funds to purchase notes and bonds and subsequently sell them to the Fed as part of the Fed's Quantitative Easing program. As Chart #3 shows, banks were happy to hold onto trillions of the bank reserves that the Fed used to pay for the notes and bonds it purchased. This was a direct reflection of the economy's increased demand for money and money equivalents.<br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-C466vcotUy8/WpS-DZFt73I/AAAAAAAAXjE/724F5Pf2q_gdIvmCM4AFL1N2ujwojaaUQCLcBGAs/s1600/Savings%2Bdeposit%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1154" height="236" src="https://2.bp.blogspot.com/-C466vcotUy8/WpS-DZFt73I/AAAAAAAAXjE/724F5Pf2q_gdIvmCM4AFL1N2ujwojaaUQCLcBGAs/s400/Savings%2Bdeposit%2Bgrowth.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: center;">Chart #5&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-g4XGe-1uqbE/WpWk9zkqA3I/AAAAAAAAXkw/epL7YNP-_RcQTokTaR6J8YAOWhSTHjxYwCLcBGAs/s1600/Conference%2BBoard.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="660" data-original-width="1142" height="232" src="https://1.bp.blogspot.com/-g4XGe-1uqbE/WpWk9zkqA3I/AAAAAAAAXkw/epL7YNP-_RcQTokTaR6J8YAOWhSTHjxYwCLcBGAs/s400/Conference%2BBoard.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div>But as Charts #4 and #5 show, beginning in 2017 the growth of savings deposits collapsed as consumer confidence surged. People no longer want to accumulate piles of cash. Instead, they have become more willing to bear risk. Not surprisingly, the stock market has experienced heady growth over the same period (see Chart #16 below). The public's demand for money has begun to decline, and the Fed is thus obliged to shrink the supply of money by reversing its balance sheet expansion. The Fed is also correct to raise short-term rates in order to boost the attractiveness of all the excess bank reserves still held by banks, lest they be tempted to lend excessively and thus further expand the money supply at a time of dwindling money demand.<br /><br /><div style="text-align: center;">Chart #6</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-vwYp4DQCtiM/WpWkruZ6UzI/AAAAAAAAXks/gm68ElzjKwEQgohw5Q8r4c9h11IDjE2mACLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://1.bp.blogspot.com/-vwYp4DQCtiM/WpWkruZ6UzI/AAAAAAAAXks/gm68ElzjKwEQgohw5Q8r4c9h11IDjE2mACLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div><div style="text-align: center;">Chart #7</div><a href="https://1.bp.blogspot.com/-d1Lvi29E_JI/WpS-y0uKMFI/AAAAAAAAXjU/Xcf0NYPjJNM0qWEq4HW-YrBP__nfPkPfgCLcBGAs/s1600/Real%2BFFs%2Bvs%2Bslope.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="660" data-original-width="1098" height="241" src="https://1.bp.blogspot.com/-d1Lvi29E_JI/WpS-y0uKMFI/AAAAAAAAXjU/Xcf0NYPjJNM0qWEq4HW-YrBP__nfPkPfgCLcBGAs/s400/Real%2BFFs%2Bvs%2Bslope.jpg" width="400" /></a><br /><br />Charts #6 and #7 show that to date the Fed has only pushed rates modestly higher. Chart #6 compares the current, inflation-adjusted overnight Fed funds rate (blue), which today is about zero, to the 5-yr real yield on TIPS, which is the market's estimate of what the blue line will average over the next 5 years, and which today is about 0.5%. Chart #7 shows the same real Fed funds rate as shown in Chart #6 in an historical context; note that real rates typically have been at least 3-4% before the onset of a recession. Chart #7 also shows the slope of the Treasury yield curve, which is typically flat or inverted prior to recessions (a flat or inverted curve is the bond market's way of saying it thinks the Fed has tightened enough or perhaps too much, and that lower rates thus lie ahead). Recessions typically happen when real borrowing costs are high and the yield curve is flat or inverted. Currently, we have neither such condition.<br /><br />It's important here to note that prior to 2009, the only way the Fed could push short-term rates higher was by restricting the supply of bank reserves. Thus, monetary "tightening" involved not only higher interest rates but also a scarcity of liquidity in the banking system; at some point the combination of the two can be lethal. That's not the case at all today, as Chart #3 illustrates. Today, liquidity is plentiful, real borrowing costs are very low, and the yield curve is within "normal" ranges. The risk of recession is thus very low.<br /><br /><div style="text-align: center;">Chart #8</div><a href="https://1.bp.blogspot.com/-wdPLPqg8at8/WpWiOrpBDFI/AAAAAAAAXkM/8Wq3lSEdGXM3IejhxpuqocdmU2k8Y-zZgCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://1.bp.blogspot.com/-wdPLPqg8at8/WpWiOrpBDFI/AAAAAAAAXkM/8Wq3lSEdGXM3IejhxpuqocdmU2k8Y-zZgCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #9</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-VW8EtHMli10/WpWh-T82AiI/AAAAAAAAXkI/UlpPpRKt68sPqPeOibUkw8FFPk0N6HDqgCLcBGAs/s1600/Nominal%2Bvs%2BReal%2BYields.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="688" data-original-width="1188" height="232" src="https://2.bp.blogspot.com/-VW8EtHMli10/WpWh-T82AiI/AAAAAAAAXkI/UlpPpRKt68sPqPeOibUkw8FFPk0N6HDqgCLcBGAs/s400/Nominal%2Bvs%2BReal%2BYields.jpg" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: left;">As Charts #8 and #9 show, inflation expectations over the next 5 and 10 years remain well within historical ranges (currently both are about 2.15%). The bond market is not concerned about either inflation or deflation or the Fed's ability to hit its 2% inflation target.</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #10</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-ETccxqwcpUQ/WpWjorpua9I/AAAAAAAAXkg/ff8GkG2XqeYy_3CaKaNZoRV8NHsEQY43gCLcBGAs/s1600/2-yr%2BSwap%2BSpreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1128" height="251" src="https://4.bp.blogspot.com/-ETccxqwcpUQ/WpWjorpua9I/AAAAAAAAXkg/ff8GkG2XqeYy_3CaKaNZoRV8NHsEQY43gCLcBGAs/s400/2-yr%2BSwap%2BSpreads.jpg" width="400" /></a></div><div style="text-align: center;">Chart #11</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-bVs4WawoGIs/WpWjH6Mwv1I/AAAAAAAAXkY/yTm3b1T6fuMEaXJ64x3BnYqtIi-mCbeOACLcBGAs/s1600/CDS%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1260" height="216" src="https://4.bp.blogspot.com/-bVs4WawoGIs/WpWjH6Mwv1I/AAAAAAAAXkY/yTm3b1T6fuMEaXJ64x3BnYqtIi-mCbeOACLcBGAs/s400/CDS%2Bspreads.jpg" width="400" /></a></div><br />As Charts #10 and #11 show, swap and credit spreads are relatively low and very much in line with "normal" conditions. The market's expectations for growth and profitability are healthy.<br /><br /><div style="text-align: center;">Chart #12</div><a href="https://3.bp.blogspot.com/-8H34nyInxfU/WpS9ZZVCASI/AAAAAAAAXiw/zELVF2pmgIAfuO1wtOzp6elAKQrMbk-PwCLcBGAs/s1600/C%2526I%2BLoans%2B%2525%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="682" data-original-width="1108" height="245" src="https://3.bp.blogspot.com/-8H34nyInxfU/WpS9ZZVCASI/AAAAAAAAXiw/zELVF2pmgIAfuO1wtOzp6elAKQrMbk-PwCLcBGAs/s400/C%2526I%2BLoans%2B%2525%2BGDP.jpg" width="400" /></a><br /><br /><div style="text-align: center;">Chart #13</div><a href="https://2.bp.blogspot.com/-krDayKcubPA/WpS9OOBEQ4I/AAAAAAAAXis/vtcefOiFqp4Ta9bZvODKaJrayCC-uIIZQCLcBGAs/s1600/All%2Bloans%2Bleases%2Bdelinq%2Brate.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" data-original-height="684" data-original-width="1092" height="250" src="https://2.bp.blogspot.com/-krDayKcubPA/WpS9OOBEQ4I/AAAAAAAAXis/vtcefOiFqp4Ta9bZvODKaJrayCC-uIIZQCLcBGAs/s400/All%2Bloans%2Bleases%2Bdelinq%2Brate.jpg" width="400" /></a><br /><br />Chart #12 shows that bank lending to small and medium-sized businesses has been stagnant of late, after reaching a relatively high level compared to the size of the economy. But as Chart #13 shows, the slowdown in lending has little or nothing to do with the health of borrowers; delinquency rates for all bank loans and leases are at historically low levels. Credit expansion is slow, but not because banks are actively restricting lending; rather, borrowers are less willing to borrow these days. That's a healthy situation, not a cause for concern.<br /><br /><div style="text-align: center;">Chart #14</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-Ylp0vLt7FGE/WpWPsjBIa3I/AAAAAAAAXj4/R7FLW6tmiewax908yNbSJTWy49pLTQLbwCLcBGAs/s1600/30-yr%2Bfixed%2Bmtg%2Brates.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://1.bp.blogspot.com/-Ylp0vLt7FGE/WpWPsjBIa3I/AAAAAAAAXj4/R7FLW6tmiewax908yNbSJTWy49pLTQLbwCLcBGAs/s400/30-yr%2Bfixed%2Bmtg%2Brates.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #15</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-RaNZlkZnBwU/WpXBCQILv_I/AAAAAAAAXlU/4ENb7r567ug5WjAoa2qZwzuzBAgW45KlQCLcBGAs/s1600/Housing%2BStarts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="688" data-original-width="1212" height="226" src="https://4.bp.blogspot.com/-RaNZlkZnBwU/WpXBCQILv_I/AAAAAAAAXlU/4ENb7r567ug5WjAoa2qZwzuzBAgW45KlQCLcBGAs/s400/Housing%2BStarts.jpg" width="400" /></a></div><div style="text-align: center;"><br /></div>Meanwhile, as Chart #14 shows, mortgage rates haven't changed much in the past several years, despite the rise in Treasury yields. That helps explain why the outlook for residential construction remains upbeat, as shown in Chart #15.<br /><br /><div style="text-align: center;">Chart #16</div><div class="separator" style="clear: both; text-align: center;"></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-uGyMEmn2Nec/WpXbW5at93I/AAAAAAAAXlk/s3v9ue7633M-ZbYuh0Yr9QWYK18incMyQCLcBGAs/s1600/Walls%2Bof%2Bworry.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1244" height="220" src="https://3.bp.blogspot.com/-uGyMEmn2Nec/WpXbW5at93I/AAAAAAAAXlk/s3v9ue7633M-ZbYuh0Yr9QWYK18incMyQCLcBGAs/s400/Walls%2Bof%2Bworry.jpg" width="400" /></a></div><br />Despite all the good news about financial market conditions and the economy, the market is still having trouble digesting the new reality of higher interest rates. But as Chart #16 suggests, the market has surmounted at least half of the recent "wall of worry." I would reiterate my earlier views that higher rates are not necessarily a bad thing—especially since they result from a stronger economy—but nevertheless higher rates pose competition for the earnings yield on stocks. Consequently, further gains in equity valuations are more likely to come from higher earnings than from expanding multiples. Total equity returns are likely to be decent going forward, but substantially less than we have seen in recent years, which is why I'm "moderately bullish."&nbsp;</div>Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com13tag:blogger.com,1999:blog-6616959642391988608.post-65094031565068603642018-02-11T17:06:00.000-08:002018-02-11T18:04:22.495-08:00One more wall of worry<div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-wHzHE0PB7U0/Wn-bPV_I4dI/AAAAAAAAXf4/-vwB-oQ32V4UXiXcVrxD8lo96E3UMHXAgCLcBGAs/s1600/Walls%2Bof%2Bworry.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="718" data-original-width="1244" height="232" src="https://3.bp.blogspot.com/-wHzHE0PB7U0/Wn-bPV_I4dI/AAAAAAAAXf4/-vwB-oQ32V4UXiXcVrxD8lo96E3UMHXAgCLcBGAs/s400/Walls%2Bof%2Bworry.jpg" width="400" /></a></div><br />I've featured this chart numerous times in recent years. What it shows is that every significant decline in stock prices in recent years has coincided with a spike in market nervousness (which I define by dividing the Vix index by the yield on 10-yr Treasuries—this measure increases as nervousness rises and yields decline, and vice versa). To date, all those "panic attacks" have proved unfounded—the economy kept on growing at a modest pace. I'm guessing that the current bout of nerves is being driven primarily by rising bond yields, which in turn are the natural result of improving economic fundamentals that are laying the groundwork for a stronger economy. There are other worries at work, to be sure, and the list would include 1) concerns that the Fed is going to be spooked by rising inflation expectations and stronger growth and thus tighten too much, 2) volatility hedgers caught in a squeeze, 3) concerns that valuations are too high, and/or 4) the combination of tax cuts and increased spending which could lead to more trillion-dollar budget deficits.<br /><br />So, as has been the case during most of the bouts of nervousness in recent years, there is no shortage of things to worry about. But, I would argue, the main thing to worry about is the health of the economy. If the economy continues to strengthen, that will "trump" just about all the above worries. For example, if the deficit increases temporarily but we end up with a stronger economy, the burden of debt will likely decline. So let's review some key economic and financial market fundamentals, all of which are quite positive. (All charts reflect the most recent data available as of February 9th.)<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-NTX6Rzq1gao/WoCB0yXtzVI/AAAAAAAAXho/uHk6DHV9Gz09s6nw25GgMsKEzHh2iZk9gCLcBGAs/s1600/2-yr%2BSwaps%2B89.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1134" height="241" src="https://2.bp.blogspot.com/-NTX6Rzq1gao/WoCB0yXtzVI/AAAAAAAAXho/uHk6DHV9Gz09s6nw25GgMsKEzHh2iZk9gCLcBGAs/s400/2-yr%2BSwaps%2B89.jpg" width="400" /></a></div><br />Chart #1 shows that 2-yr swap spreads (a highly liquid and reliable measure of generic, high-quality credit risk) have increased only slightly during the recent equity selloff, and remain well with a "normal" range. This further indicates that financial markets are liquid and that financial market fundamentals are healthy. Historically, swap spreads have been good predictors of recessions and recoveries, rising in advance of recessions and declining in advance of recoveries.<br /><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-DfaGIxeWUig/WoCBVBZwtsI/AAAAAAAAXhg/xoabTq7haX4HVNn__Yyptlp6jXbZGvgqQCLcBGAs/s1600/2-yr%2BSwap%2BSpreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1132" height="250" src="https://3.bp.blogspot.com/-DfaGIxeWUig/WoCBVBZwtsI/AAAAAAAAXhg/xoabTq7haX4HVNn__Yyptlp6jXbZGvgqQCLcBGAs/s400/2-yr%2BSwap%2BSpreads.jpg" width="400" /></a></div><br />Chart #2 compares swap spreads here with those in the Eurozone. Notably, Eurozone financial fundamentals have been improving of late. No hint of trouble either here or abroad.<br /><br /><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-6Pi5v0_pVfo/WoCCp7Bmo6I/AAAAAAAAXh0/0yU5qW4L6XQ6-CCYNdejfhsA1WG2zUm2QCLcBGAs/s1600/HY%2Bvs%2B2-yr%2Bswaps.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="770" data-original-width="1248" height="248" src="https://4.bp.blogspot.com/-6Pi5v0_pVfo/WoCCp7Bmo6I/AAAAAAAAXh0/0yU5qW4L6XQ6-CCYNdejfhsA1WG2zUm2QCLcBGAs/s400/HY%2Bvs%2B2-yr%2Bswaps.jpg" width="400" /></a></div><br />Chart #3 shows that swap spreads have also been good predictors of credit spreads in general. Currently there is little reason to be concerned.<br /><div style="text-align: center;"><br /></div><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-5AGHvdlr6-w/WoCC5iR7fyI/AAAAAAAAXh4/2alzKA7Smsk95RgVIVcezJOXDrilq0H1ACLcBGAs/s1600/IG%2Bvs%2BHY%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="694" data-original-width="1198" height="232" src="https://2.bp.blogspot.com/-5AGHvdlr6-w/WoCC5iR7fyI/AAAAAAAAXh4/2alzKA7Smsk95RgVIVcezJOXDrilq0H1ACLcBGAs/s400/IG%2Bvs%2BHY%2Bspreads.jpg" width="400" /></a></div><br />Chart #4 shows that both high- and low-quality corporate credit spreads are relatively low, having risen only marginally in the past week. This indicates that the bond market is not very concerned at all about the quality of earnings or the health of the economy.<br /><br /><div style="text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-Qw9SpQ0vMFk/WoB-Od0vRUI/AAAAAAAAXhM/WvJAJQB6uUwbIghIHFjt_wtASywF2wkuQCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://3.bp.blogspot.com/-Qw9SpQ0vMFk/WoB-Od0vRUI/AAAAAAAAXhM/WvJAJQB6uUwbIghIHFjt_wtASywF2wkuQCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a></div><br />Chart #5 shows the nominal and real yields on 5-yr Treasuries, and the difference between the two, which is the market's expected annual rate of inflation over the next 5 years. Inflation expectations are well-anchored at just slight above 2%. It's tough to conclude from this that the market is concerned about either too much or too little inflation. Current inflation expectations are very much in line with what we have seen in recent decades.<br /><br /><div style="text-align: center;">Chart #6</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-ZMZc0FmDiu0/WoB-iN61S3I/AAAAAAAAXhQ/SeqnjKUttL82K8IC_pdLFwPhQNQ-L8zTQCLcBGAs/s1600/Nominal%2Bvs%2BReal%2BYields.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="688" data-original-width="1188" height="232" src="https://4.bp.blogspot.com/-ZMZc0FmDiu0/WoB-iN61S3I/AAAAAAAAXhQ/SeqnjKUttL82K8IC_pdLFwPhQNQ-L8zTQCLcBGAs/s400/Nominal%2Bvs%2BReal%2BYields.jpg" width="400" /></a></div><br />Chart #6 shows the same comparison as Chart #5 for 10-yr Treasuries and expected inflation over the next 10 years. Again, current expectations are very much in line with past experience.<br /><br /><div class="separator" style="clear: both; text-align: center;"></div><div style="text-align: center;">Chart #7&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-dVOtyWEsSa8/WoCFEKuuyHI/AAAAAAAAXiE/SxhPThmT9f8PcHznIpzPTQMc52OpBz-_gCLcBGAs/s1600/Real%2BBroad%2BDollar%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1136" height="241" src="https://2.bp.blogspot.com/-dVOtyWEsSa8/WoCFEKuuyHI/AAAAAAAAXiE/SxhPThmT9f8PcHznIpzPTQMc52OpBz-_gCLcBGAs/s400/Real%2BBroad%2BDollar%2BIndex.jpg" width="400" /></a></div><br />Chart #7 shows two measures of the dollar's value vis a vis other currencies, on a trade-weighted and inflation-adjusted basis. These are arguably the best available measures of the dollar's relative value against other currencies. What we see is that the dollar today is roughly equal to or slightly above its long-term historical average.<br /><br /><div style="text-align: center;">Chart #8</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-2zffssdi7hE/WoCFW7-NSCI/AAAAAAAAXiI/7r9FG38990EyaiA9oLhhr531P4C8gp7dQCLcBGAs/s1600/Screen%2BShot%2B2018-02-11%2Bat%2B10.02.37%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1079" data-original-width="1600" height="270" src="https://2.bp.blogspot.com/-2zffssdi7hE/WoCFW7-NSCI/AAAAAAAAXiI/7r9FG38990EyaiA9oLhhr531P4C8gp7dQCLcBGAs/s400/Screen%2BShot%2B2018-02-11%2Bat%2B10.02.37%2BAM.png" width="400" /></a></div><br />Chart #8 shows a simpler measure of the dollar vis a vis major currencies since the beginning of last year. The dollar has been declining meaningfully over this period. Taken alone, this would suggest that the market has either become bearish on the outlook for the US economy and/or concerned that the Fed has been too complacent about raising interest rates. I'm inclined toward the latter explanation, since it's hard to believe the world has ignored the many signs of improvement in the US economy over the past year.<br /><br />As I've explained before, over the past year we have seen accumulating evidence that the demand for money in the US has been weakening. That's the natural result of a return of confidence and a growing desire on the part of the public to become less risk-averse. Yet the Fed has been slow to take offsetting measures (e.g., by raising short-term interest rates and/or draining excess reserves, which remain quite abundant). In short, this suggests that the Fed has fallen a bit "behind the curve." They haven't kept the supply of dollars and the demand for dollars in balance; the result has been a surplus of dollars and thus a weaker dollar. This has shown up as well in higher gold and commodity prices in the past year. If the dollar were to weaken more I would become concerned, but for now, with inflation expectations still reasonable, it is premature to conclude that the Fed has made a big mistake. I am somewhat reassured by the recent decline in gold, commodity prices, and oil prices that has occurred opposite the strengthening of the dollar.<br /><br /><div style="text-align: center;">Chart #9</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-rki4fVimGnc/Wn-mluovC0I/AAAAAAAAXgo/cz7hsi7xnyc02T9EypTkxrlWaGr562f_QCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://1.bp.blogspot.com/-rki4fVimGnc/Wn-mluovC0I/AAAAAAAAXgo/cz7hsi7xnyc02T9EypTkxrlWaGr562f_QCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><br />Chart #9 compares the real yield on 5-yr TIPS with the 2-yr annualized growth of the US economy. It strongly suggests that real yields over time tend to follow the real rate of growth in the economy. The recent rise in real yields—which is still modest—tracks very well with the growing perception that the rate of growth in the US economy is picking up. In fact, over the last three quarters the economy has grown at a 2.9% annualized rate, which is comfortably above the 2.2% rate it has averaged since the recovery began in mid-2009. Growth expectations from the NY and Atlanta Fed offices put first quarter GDP growth at somewhere between 3.3% and 4%.<br /><br /><i>The rise in rates is thus fully explained by the improvement in the outlook for growth</i>, and is nothing to be concerned about. There is no <i>a priori</i> reason equities can't continue to rise in value even if stronger growth results in higher interest rates. But it is nevertheless likely that higher interest rates will tend to depress PE ratios and thus keep future equity returns more modest than we have seen in the past.<br /><br /><div style="text-align: center;">Chart #10</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-lKeicgWbL1c/Wn-m2tYfIDI/AAAAAAAAXgw/NZtzoDBfmwYDFTjy0TLWNvQ2y97rsRcTQCLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://4.bp.blogspot.com/-lKeicgWbL1c/Wn-m2tYfIDI/AAAAAAAAXgw/NZtzoDBfmwYDFTjy0TLWNvQ2y97rsRcTQCLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><br />Chart #10 compares the real yield on 5-yr TIPS with the inflation-adjusted Fed funds rate. The blue line is the overnight real short-term interest rate, while the red line is the market's expectation for what the blue line will average over the next 5 years. This tells us that the market expects only a modest amount of "tightening" from the Fed in coming years. The slope of the real yield curve today is positive; if it were negative, that would be a sign that the market thinks the Fed has tightened too much and will need to lower rates in the future.<br /><br /><div style="text-align: center;">Chart #11</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-4UcgnLkinPY/WoB9RaGhL7I/AAAAAAAAXhE/jGAABun4NBsn7sVoHhf5S7n5T37tX90nwCLcBGAs/s1600/Yields%2Band%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="722" data-original-width="1214" height="240" src="https://1.bp.blogspot.com/-4UcgnLkinPY/WoB9RaGhL7I/AAAAAAAAXhE/jGAABun4NBsn7sVoHhf5S7n5T37tX90nwCLcBGAs/s400/Yields%2Band%2Bspreads.jpg" width="400" /></a></div>Chart #11 looks at the nominal yield curve, from 2 years to 10 years. Rates have risen and the curve has flattened in recent years, which is very much in line with what one would expect when the economy is growing. But importantly, the yield curve is not flat nor is it negative. During most of the fast-growing 1990s, the curve was actually a bit flatter than it is now. So it's hard to get concerned about recent developments in the yield curve.<br /><br /><div style="text-align: center;">Chart #12</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-aYqasHY8mlk/WoCGwCYc3AI/AAAAAAAAXiY/vTvtlsshJQcPpKl_W2GJDXlxk99gXVoCACLcBGAs/s1600/Real%2BFFs%2Bvs%2Bslope.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="660" data-original-width="1098" height="241" src="https://4.bp.blogspot.com/-aYqasHY8mlk/WoCGwCYc3AI/AAAAAAAAXiY/vTvtlsshJQcPpKl_W2GJDXlxk99gXVoCACLcBGAs/s400/Real%2BFFs%2Bvs%2Bslope.jpg" width="400" /></a></div><br />Chart #12 is the classic way to see whether the economy is at risk of recession. Recessions have always been preceded by a substantial increase in real short-term interest rates (blue line) and a flat or negatively-sloped yield curve (red line). Today we are not even close to the conditions that would suggest a near-term risk of recession. That's another way of saying that the Fed is not even remotely too tight, nor is it expected to be any time in the foreseeable future.<br /><br />It's also important to note that excess bank reserves are still abundant (about $2 trillion). Past recessions were triggered by very tight Fed policy, when the Fed drained bank reserves and squeezed liquidity in order to boost short-term interest rates. Today, thanks to an important change in the Fed's operating policy in late 2008, the Fed can tighten by either draining reserves (but it might take a long time to create a scarcity), and/or directly raising short-term interest rates. To date they have done neither in a way that might be considered a threat to financial stability. They have merely nudged rates higher in response to a healthier economy.<br /><br /><div style="text-align: center;">Chart #13</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-rlbtNuPm2d0/Wn-lpceQVpI/AAAAAAAAXgM/ppQRS0SgYGsRE2wyJUgoHroT9DfuYw_HgCLcBGAs/s1600/NAPM%2Bvs%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1226" height="232" src="https://4.bp.blogspot.com/-rlbtNuPm2d0/Wn-lpceQVpI/AAAAAAAAXgM/ppQRS0SgYGsRE2wyJUgoHroT9DfuYw_HgCLcBGAs/s400/NAPM%2Bvs%2BGDP.jpg" width="400" /></a></div><br />Meanwhile, the signs of improving economic fundamentals are abundant and impressive. Chart #13 suggests that the current health of the manufacturing sector is consistent with a substantial pickup in overall growth.<br /><br /><div style="text-align: center;">Chart #14</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-LM3Fhvxk8S0/Wn-lx-CbfvI/AAAAAAAAXgQ/UYgKqLlAp00sih2GakM5wkw-ncBnTtYJACLcBGAs/s1600/NAPM%2BExports.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1110" height="245" src="https://3.bp.blogspot.com/-LM3Fhvxk8S0/Wn-lx-CbfvI/AAAAAAAAXgQ/UYgKqLlAp00sih2GakM5wkw-ncBnTtYJACLcBGAs/s400/NAPM%2BExports.jpg" width="400" /></a></div><br />Chart #14 shows that manufacturers are experiencing healthy demand from overseas. The US is improving and so is the rest of the world. That's a heady combination.<br /><br /><div style="text-align: center;">Chart #15</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-mNgRP0wc-yw/Wn-l-eVMMmI/AAAAAAAAXgY/N5d_IrE_wYoNUDbcdIXZ7I0K_bKsCgntQCLcBGAs/s1600/ISM%2BService%2Bemployment.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1116" height="243" src="https://1.bp.blogspot.com/-mNgRP0wc-yw/Wn-l-eVMMmI/AAAAAAAAXgY/N5d_IrE_wYoNUDbcdIXZ7I0K_bKsCgntQCLcBGAs/s400/ISM%2BService%2Bemployment.jpg" width="400" /></a></div><br />Chart #15 shows that the all-important service sector is expecting to increase hiring significantly in coming months. This is consistent with surveys of consumer and small business confidence, all of which are showing a big improvement over the past year.<br /><br /><div style="text-align: center;">Chart #16</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-12_pmQGrU_Y/Wn-mHbviYwI/AAAAAAAAXgc/i8dfMYiht0sizTjVOWNVpBF09MYqTx8KACLcBGAs/s1600/US%2Bvs%2BEurozone%2BMan.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1132" height="241" src="https://2.bp.blogspot.com/-12_pmQGrU_Y/Wn-mHbviYwI/AAAAAAAAXgc/i8dfMYiht0sizTjVOWNVpBF09MYqTx8KACLcBGAs/s400/US%2Bvs%2BEurozone%2BMan.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #17</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-UmFWVV6HKpo/Wn-mQvUaPkI/AAAAAAAAXgk/r0WaYX1Dv6YF7yQyx8HTxkAl_UJDq03lQCLcBGAs/s1600/US%2Bvs%2BEurozone%2BServ.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1126" height="241" src="https://2.bp.blogspot.com/-UmFWVV6HKpo/Wn-mQvUaPkI/AAAAAAAAXgk/r0WaYX1Dv6YF7yQyx8HTxkAl_UJDq03lQCLcBGAs/s400/US%2Bvs%2BEurozone%2BServ.jpg" width="400" /></a></div><br />Charts #16 and #17 compare—vary favorably—the health of the manufacturing and service sectors in the US and Eurozone. All are looking about as good as it gets.<br /><br /><div style="text-align: center;">Chart #18</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-8nD60JTYHsw/Wn-lY96TExI/AAAAAAAAXgI/ZrldQxrBTM4Rkf4_djz-jZBo65mJpvdjACLcBGAs/s1600/S%2526P%2B500%2BPE.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1134" height="241" src="https://3.bp.blogspot.com/-8nD60JTYHsw/Wn-lY96TExI/AAAAAAAAXgI/ZrldQxrBTM4Rkf4_djz-jZBo65mJpvdjACLcBGAs/s400/S%2526P%2B500%2BPE.jpg" width="400" /></a></div><br />As for equity valuations, Chart #18 reflects the recent decline in the PE ratio (using trailing 12-month earnings) of the S&amp;P 500 to 21.1. The one-year forward PE ratio is now only 15.2, only slightly above its long-term average. Trailing 12-month earnings are up almost 13% as of January '18, and sharply lower corporate tax rates going forward can only boost them further. Stocks are no longer cheap, that's for sure, but neither are they are egregiously overvalued.<br /><br />The current selloff may well continue for awhile, but sooner or later the reality of a stronger economy and a non-threatening Fed likely will allow the market to overcome this latest wall of worry.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com40tag:blogger.com,1999:blog-6616959642391988608.post-85207233697146117102018-01-30T11:20:00.000-08:002018-01-30T11:20:04.475-08:00Rising bond yields are a good thingStocks are nervous because bond yields are rising. As I noted six weeks ago, the <a href="http://scottgrannis.blogspot.co.nz/2017/12/the-bond-market-begins-to-figure-things.html">bond market is beginning to figure things out</a>: corporate tax cuts are going to lead to a stronger-than-expected economy, and that in turn means the Fed is going to have to raise rates by more than expected. The key 5-yr real yield on TIPS is now 0.45%, and that's 65 bps higher than it was a year ago. 10-yr Treasury yields are 2.73% today, and it looks more and more like the epic bond bull market is a thing of the past. We're still in the early innings, however.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-mGY7uCM93iI/WnC-viMwj9I/AAAAAAAAXfI/NAEkClJ2RSMMN0YI0UxnKkFsSgftkcg_ACLcBGAs/s1600/10-YR%2BYIELDS%2B89-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1122" height="241" src="https://1.bp.blogspot.com/-mGY7uCM93iI/WnC-viMwj9I/AAAAAAAAXfI/NAEkClJ2RSMMN0YI0UxnKkFsSgftkcg_ACLcBGAs/s400/10-YR%2BYIELDS%2B89-.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #1 updates Chart #4 from <a href="http://scottgrannis.blogspot.co.nz/2018/01/putting-bonds-and-stocks-into.html">this post</a> earlier this month. The downtrend in bond yields looks to have been broken, and there is plenty of room for yields to move higher still.&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-ECChof0hpzA/WnC-7kfl5PI/AAAAAAAAXfM/4tRT1ii9Dwwxs9XJJH-0HuNBxcGqCzDSgCLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://2.bp.blogspot.com/-ECChof0hpzA/WnC-7kfl5PI/AAAAAAAAXfM/4tRT1ii9Dwwxs9XJJH-0HuNBxcGqCzDSgCLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><br />Chart #2 compares the all-important 5-yr real yield on TIPS with the current real Fed funds rate. The spread between the two is widening, which means the market is pricing in more Fed tightening than it had previously expected. This is good.<br /><br />But there are still some troubling signs which suggest the market is not yet convinced that the Fed is going to be tightening by as much as it should, given the decline in the demand for money, as I noted in Chart #5 in <a href="http://scottgrannis.blogspot.co.nz/2018/01/worrying-about-rising-confidence.html">this post</a>. Gold prices are down a bit from their recent highs, but I'd like to see them lower still. The dollar has been steady for the past few days, but it is still down by over 10% in the past year. If the market were convinced that the economy was strengthening and the Fed would be raising real rates in tandem, then I have to believe the dollar would be a lot stronger and gold weaker. These are things to watch carefully as the year progresses. As I say, we're still in the early innings in all of this.<br /><br />I'm doing my best to keep up, despite having a great time traveling through New Zealand, a trip that has long been on our bucket list.<br /><br />Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com28tag:blogger.com,1999:blog-6616959642391988608.post-86006585085803645432018-01-19T12:19:00.000-08:002018-01-19T12:19:54.135-08:00Putting bonds and stocks into perspectiveThere are some big things happening in the financial markets. Stocks are hitting record highs and bond yields are bouncing off record lows. The S&amp;P 500 index is up almost 35% since just before the November '16 election. 10-yr T-bond yields are now 2.64%, almost twice as high as their all-time record low of 1.36% in July '16.<br /><br />For some valuable perspective, I offer the following charts:<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-dRMEdLxjgM8/WmJHpZynwuI/AAAAAAAAXd0/psVnP4o6I-kKL-f6uBC3luV_qgM8xrnzgCLcBGAs/s1600/S%2526P%2B500.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="674" data-original-width="1158" height="232" src="https://3.bp.blogspot.com/-dRMEdLxjgM8/WmJHpZynwuI/AAAAAAAAXd0/psVnP4o6I-kKL-f6uBC3luV_qgM8xrnzgCLcBGAs/s400/S%2526P%2B500.jpg" width="400" /></a></div><br />In Chart #1, I've drawn some admittedly arbitrary trend lines on this long-term chart of the S&amp;P 500 index. The trend rate of growth they represent is a bit conservative compared to the 9.4% annualized long-term total return (including dividends) of stocks since 1927, according to Bloomberg. Stocks appear to be pushing the upper limits of growth, according to this chart. But further gains cannot be ruled out. After all, last year's tax reform slashed the corporate income tax rate from 35% to 21%, making future earnings streams suddenly worth 21% more.<br /><br /><div style="text-align: center;">Chart #2&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-SGy_EUU_zF8/WmJHyyx3q2I/AAAAAAAAXd4/RxXvFxZtV2ApQvM1KCKzUMxHGXMsTQRtACLcBGAs/s1600/Real%2BSP%2B500%2B50-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1150" height="235" src="https://4.bp.blogspot.com/-SGy_EUU_zF8/WmJHyyx3q2I/AAAAAAAAXd4/RxXvFxZtV2ApQvM1KCKzUMxHGXMsTQRtACLcBGAs/s400/Real%2BSP%2B500%2B50-.jpg" width="400" /></a></div><br />Chart #2 adjusts the S&amp;P 500 index for the rate of consumer price inflation. The trend lines I've drawn represent 3% annualized real growth, which is very much in line with the economy's long-term trend growth rate. Still room on the upside, considering recent tax cuts. If businesses respond to their new investment incentives, we could see the economy grow by substantially more than 3% in coming years.<br /><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-NJ7F5SIZC2Q/WmJH-WwRFjI/AAAAAAAAXd8/ep6MSu0xQu8Vkxcw-YkIfETIzVHM2rMtACLcBGAs/s1600/10-yr%2BTreasury%2Byields%2B25-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1204" height="226" src="https://3.bp.blogspot.com/-NJ7F5SIZC2Q/WmJH-WwRFjI/AAAAAAAAXd8/ep6MSu0xQu8Vkxcw-YkIfETIzVHM2rMtACLcBGAs/s400/10-yr%2BTreasury%2Byields%2B25-.jpg" width="400" /></a></div><br />Chart #3 gives you the long-term history of 10-yr Treasury yields, with the green dashed line marking the all-time closing low of 1.3% (July '16).<br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-4xR_AGm9Zn4/WmJIIWPbocI/AAAAAAAAXeE/To3XkIhDhiMGQ120DbyTM9SiqyW4qeigwCLcBGAs/s1600/10yr%2Byields.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1122" height="241" src="https://4.bp.blogspot.com/-4xR_AGm9Zn4/WmJIIWPbocI/AAAAAAAAXeE/To3XkIhDhiMGQ120DbyTM9SiqyW4qeigwCLcBGAs/s400/10yr%2Byields.jpg" width="400" /></a></div><br />Chart #4 zooms in on the last 28 years of Treasury yields. The trend line I've drawn suggests that the bond market is in the early stages of reversing its long-term declining trend. This would make sense if indeed the economy is on the cusp of a new wave of investment-led growth. If would also make sense if inflation is 2% or more, as it is today.<br /><br /><div style="text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-jhVXZ2EyWYA/WmJN2otGLYI/AAAAAAAAXeo/iw8f4LWE3-IjlOgRu1XOL-4NBRu0PtWzwCLcBGAs/s1600/10-yr%2Bvs%2BCPI.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1134" height="241" src="https://1.bp.blogspot.com/-jhVXZ2EyWYA/WmJN2otGLYI/AAAAAAAAXeo/iw8f4LWE3-IjlOgRu1XOL-4NBRu0PtWzwCLcBGAs/s400/10-yr%2Bvs%2BCPI.jpg" width="400" /></a></div><br />Chart #5 shows how 10-yr yields have been unusually low relative to inflation in the past decade or so. Since 1960, the average spread between 10-yr yields and inflation has been 2.3%, whereas today it is only 0.5%. If consumer price inflation averages just over 2% in coming years, as the breakeven spreads on TIPS and Treasuries suggest, then I would expect to see the 10-yr yield average at least 3.5 - 4%.<br /><br /><div style="text-align: center;">Chart #6&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-2MeifR0LWE8/WmJQr326AHI/AAAAAAAAXe0/LO_CI0QoA_IGE4pvCcQ71I1lAxWblzthACLcBGAs/s1600/Equity%2Bmkt%2Bcapitalization.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1196" height="226" src="https://2.bp.blogspot.com/-2MeifR0LWE8/WmJQr326AHI/AAAAAAAAXe0/LO_CI0QoA_IGE4pvCcQ71I1lAxWblzthACLcBGAs/s400/Equity%2Bmkt%2Bcapitalization.jpg" width="400" /></a></div><br />Chart #6 compares the equity market capitalization of global equities and US equities, according to Bloomberg. A lot of wealth has been created in recent years.<br /><br /><div style="text-align: center;">Chart #7</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-aUnY-9tN8lc/WmJId857sYI/AAAAAAAAXeU/d-lyg-DdjUsYXZU4MEIkli7Gd9nEGHaNACLcBGAs/s1600/US%2Bv%2BNonUS%2Bmkt%2Bcap.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1176" height="232" src="https://3.bp.blogspot.com/-aUnY-9tN8lc/WmJId857sYI/AAAAAAAAXeU/d-lyg-DdjUsYXZU4MEIkli7Gd9nEGHaNACLcBGAs/s400/US%2Bv%2BNonUS%2Bmkt%2Bcap.jpg" width="400" /></a></div><br />Chart #7 shows that it's not just the US equity market that is on fire. For the past several years, the US and non-US equity markets have appreciated by roughly the same amount. Since 2004, US equity capitalization has actually fallen significantly relative to the rest of the world. We're smack in the middle of a global equity market boom and the US market does not stick out like a sore thumb.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com15tag:blogger.com,1999:blog-6616959642391988608.post-10035713328737487022018-01-11T11:13:00.001-08:002018-01-12T07:29:56.511-08:00Worrying about rising confidenceConfidence is high and risk-taking is on the rise, and that is <a href="http://scottgrannis.blogspot.com/2017/08/something-to-worry-about.html">something to worry about</a>. It's not because equity prices are soaring and therefore downside bubble-popping risks are greater. It's because more confidence and a greater willingness to take on risk mean that the demand for money is declining, but the Fed—at least for now—is reluctant to move aggressively to offset the decline in money demand by boosting short-term rates and draining excess reserves. As Milton Friedman taught us years ago, inflation is a monetary phenomenon which results from an excess of money relative to the demand for it. Today we have declining money demand at a time when the supply of money remains abundant (e.g., $2 trillion of excess bank reserves) and interest rates remain very low. It's likely that because of this we are seeing the early signs of rising inflation in the form of higher prices for sensitive assets such as gold and commodities, and a decline in the value of the dollar.<br /><br />Here's what we know so far: The boost to confidence began just over a year ago, coincident with the surprise election of Donald Trump, who promised to take radical measures to boost the economy by cutting tax and regulatory burdens. Confidence at both the consumer and small business levels promptly surged. The growth of bank savings accounts began to slow, the dollar began to decline, and gold began to rise—all such changes being symptomatic of declining money demand and the rational result of rising confidence. Now, in the past month or so, inflation expectations as embodied in TIPS and Treasury prices have risen from about 1.8% to 2.0%.<br /><br />None of this is as yet scary or off the charts, but it is worrisome. It's not too late for the Fed to step up the pace of its rate hikes and reserve draining operations, but since the market is not expecting this to happen, the reality of an unexpected rise in interest rates would be at the very least a headwind for the equity market and/or fodder for selloffs and consolidations. And if the Fed doesn't react with faster rate hikes and more reserve draining, then inflation could become embedded and difficult to tame—and before too long we'd be worried about another recession.<br /><br />I'm not saying we're on the cusp of disaster. What I'm saying is that we now have accumulating evidence and reason to be concerned about the risk of rising inflation and higher interest rates. It's great news that the economy is doing better and tax reform has passed; there is every reason to believe that the economy is headed for at least several years of much stronger growth. But the coast is not completely clear.<br /><br />In a best-case scenario, I'd like to see the bond market signal the Fed that higher rates are warranted. The collective wisdom of the bond market is arguably better than that of a handful of Fed governors. One key thing to watch for is higher real yields, since that would be an indication that the market is pricing in stronger growth, and stronger growth and higher nominal and real yields go happily hand-in-hand. So far, however, real yields remain quite subdued. To date, the move to higher yields is concentrated in the nominal space, and that means that rising inflation expectations—not stronger growth—are what's driving yields higher.<br /><br />Here's the evidence of declining money demand:<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-wfQYYI6BA_w/WlUjhxfp9HI/AAAAAAAAXbY/R-wqN3EDhkYm4iIhWqAcRGrBNIetEVM8ACLcBGAs/s1600/Small%2Bbusiness%2Boptimism.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1148" height="240" src="https://2.bp.blogspot.com/-wfQYYI6BA_w/WlUjhxfp9HI/AAAAAAAAXbY/R-wqN3EDhkYm4iIhWqAcRGrBNIetEVM8ACLcBGAs/s400/Small%2Bbusiness%2Boptimism.jpg" width="400" /></a></div><br />Small business optimism (Chart #1) surged almost immediately following the November '16 elections. It's now about as high as it has been in decades. One reason for increased business optimism is undoubtedly the <a href="https://cei.org/blog/trump-regulations-federal-register-page-count-lowest-quarter-century">huge reduction in regulatory burdens</a> that the Trump administration has managed to achieve in one short year. Under Trump's leadership, there has been a one-third reduction in the number of pages in last year's Federal Register compared to Obama's last year, and the number of rules in the 2017 Federal Register was the lowest since records were first kept in the mid-1970s. And that low figure of course includes all the rules that Trump issued to get rid of other rules, so the reality is even better than the numbers suggest. (HT: Warren Smith)<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-W5R01CWXCKI/WlUj8W-RkRI/AAAAAAAAXbc/OQMq_a5ICK8iQ4aT6F48MsIh5h_kfJwKACLcBGAs/s1600/Conference%2BBoard.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="660" data-original-width="1148" height="228" src="https://2.bp.blogspot.com/-W5R01CWXCKI/WlUj8W-RkRI/AAAAAAAAXbc/OQMq_a5ICK8iQ4aT6F48MsIh5h_kfJwKACLcBGAs/s400/Conference%2BBoard.jpg" width="400" /></a></div><br />As Chart #2 shows, consumer confidence began rising to healthy levels a few years ago. It's not yet at extremely high levels, but it is significantly better now that it was during most of the recovery years.<br /><br /><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-ObkwhSy7ypA/WlUkIhKYGiI/AAAAAAAAXbg/V9K4zLk6OKUzKYtY3akFWrbkDKXK81K3wCLcBGAs/s1600/Savings%2Bdeposits%2B08-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1130" height="241" src="https://1.bp.blogspot.com/-ObkwhSy7ypA/WlUkIhKYGiI/AAAAAAAAXbg/V9K4zLk6OKUzKYtY3akFWrbkDKXK81K3wCLcBGAs/s400/Savings%2Bdeposits%2B08-.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-Ddd9UbvBxWU/WlUkRDMlk5I/AAAAAAAAXbo/G7eGxwi75U87Tq83CHkvI3k2DxSIrNqowCLcBGAs/s1600/Savings%2Bdeposit%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1156" height="232" src="https://2.bp.blogspot.com/-Ddd9UbvBxWU/WlUkRDMlk5I/AAAAAAAAXbo/G7eGxwi75U87Tq83CHkvI3k2DxSIrNqowCLcBGAs/s400/Savings%2Bdeposit%2Bgrowth.jpg" width="400" /></a></div><br />Charts #3 and #4 are the most important of all the charts in this post. What they show is a significant reduction in the growth of bank savings deposits in recent years. The slowdown accelerated in the past year, as growth rates fell from 8% in late 2016 to 3% in late 2017. Savings accounts in the current business cycle have been excellent indicators of money demand because they have paid extremely low rates of interest; no one has put money in a savings account in order to get huge interest rate rewards. What they are looking for is safety and liquidity. Yet despite paying almost nothing, bank savings account more than doubled in the past 9 years. This can only be because people had an overwhelming desire to keep their money safe while they increased their holdings of money. But now, people are becoming less and less risk averse, and the demand for cash and cash equivalents (like savings accounts) is declining in favor of increased demand for equities and other risky assets. With more confidence comes less desire for safety and a greater desire to take on risk.<br /><br /><div style="text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-VWVD2ColMNA/WlV1Eut8t_I/AAAAAAAAXcY/LlWHDJZa5BgafAo1uAMCQWKSZgMwKXemgCLcBGAs/s1600/Money%2BDemand.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="672" data-original-width="1152" height="232" src="https://4.bp.blogspot.com/-VWVD2ColMNA/WlV1Eut8t_I/AAAAAAAAXcY/LlWHDJZa5BgafAo1uAMCQWKSZgMwKXemgCLcBGAs/s400/Money%2BDemand.jpg" width="400" /></a></div><br />Chart #5 shows how the public's desire to hold on to money increased dramatically beginning in the Great Recession. Think of M2 as a proxy for the amount of cash and cash equivalents the average person wants to hold, and nominal GDP as a proxy for the average person's annual income. The ratio of M2 to GDP peaked about six months ago, after reaching an all-time high, because there was a huge move on the part of the public to boost their stores of safe cash and cash equivalents. Since it's apparent that the public wants to shed some of its cash holdings, the only way that can happen is if there is a faster increase in nominal and real GDP. The extra amount of money that could be shed could translate into trillions of dollars of additional real and nominal GDP.<br /><br /><div style="text-align: center;">Chart #6</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-B-MEDt1ZlY4/Wle05fUFd6I/AAAAAAAAXdU/GDlyRmTFuS85ZYpTKrOYrIs5pvtph62bgCLcBGAs/s1600/Screen%2BShot%2B2018-01-11%2Bat%2B11.02.39%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1079" data-original-width="1600" height="270" src="https://1.bp.blogspot.com/-B-MEDt1ZlY4/Wle05fUFd6I/AAAAAAAAXdU/GDlyRmTFuS85ZYpTKrOYrIs5pvtph62bgCLcBGAs/s400/Screen%2BShot%2B2018-01-11%2Bat%2B11.02.39%2BAM.png" width="400" /></a></div><br /><div style="text-align: center;">Chart #7</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-6UN9PsuhHE8/Wle1iZ0D79I/AAAAAAAAXdc/SjDb6Pq7nEIzv5Da1BALZM297azlz5-gACLcBGAs/s1600/Screen%2BShot%2B2018-01-11%2Bat%2B11.05.27%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1090" data-original-width="1600" height="275" src="https://2.bp.blogspot.com/-6UN9PsuhHE8/Wle1iZ0D79I/AAAAAAAAXdc/SjDb6Pq7nEIzv5Da1BALZM297azlz5-gACLcBGAs/s400/Screen%2BShot%2B2018-01-11%2Bat%2B11.05.27%2BAM.png" width="400" /></a></div><br />Chart #6 shows an index of industrial metals prices, which have increased by almost 17% since the beginning of 2017. This undoubtedly has a lot to do with improving global growth fundamentals, as well as the decline in the value of the dollar, shown in Chart #7 (the dollar has dropped over 10% since early last year vis a vis other major currencies).<br /><br />Now a look at how inflation expectations are rising. They've increased of late, but over the past year they haven't changed much and current expectations are not out of line with historical experience:<br /><br /><div style="text-align: center;">Chart #8</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-ix4SLRz9RvQ/WlesyYqjdmI/AAAAAAAAXco/YvRhx8QJJZkkqup5LkocE5bnjWEJTvADACLcBGAs/s1600/Screen%2BShot%2B2018-01-11%2Bat%2B10.27.54%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1095" data-original-width="1600" height="275" src="https://1.bp.blogspot.com/-ix4SLRz9RvQ/WlesyYqjdmI/AAAAAAAAXco/YvRhx8QJJZkkqup5LkocE5bnjWEJTvADACLcBGAs/s400/Screen%2BShot%2B2018-01-11%2Bat%2B10.27.54%2BAM.png" width="400" /></a></div><br /><div style="text-align: center;">Chart #9</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-6-XfUWsFI74/Wles9N7ZxPI/AAAAAAAAXcs/R5OZryPKWQwiDrlPFgVPMtkMfXRy97YqwCLcBGAs/s1600/Screen%2BShot%2B2018-01-11%2Bat%2B10.28.51%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1098" data-original-width="1600" height="275" src="https://1.bp.blogspot.com/-6-XfUWsFI74/Wles9N7ZxPI/AAAAAAAAXcs/R5OZryPKWQwiDrlPFgVPMtkMfXRy97YqwCLcBGAs/s400/Screen%2BShot%2B2018-01-11%2Bat%2B10.28.51%2BAM.png" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: center;"></div>Chart #8 shows the evolution over the past year of inflation expectations for the next 5 years. The top portion of the chart shows nominal yields for 5-yr Treasuries and the real yield on 5-yr TIPS. The difference between the two—the market's expected average annual rate of inflation over the next 5 years—is shown on the bottom panel. Note that current inflation expectations are about 2%, which is modestly higher than the 1.6% average rate of CPI inflation over the past 10 years and modestly lower than the 2.15% average over the past 20 years. Current expectations are not out of line with the past, but they are near the high end of past trends. Chart #9 shows the same analysis for 10-yr Treasuries and 10-yr TIPS. Note also that over the past month or so, real yields have been relatively flat, while nominal yields have risen: that is what happens when the market expects inflation to rise but economic growth to remain modest.<br /><br /><div style="text-align: center;">Chart #10</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-RogqYKl65ro/WleuiQGcj2I/AAAAAAAAXc4/mEfYyjVraoEVVolpAMy556HDszTUyr5LACLcBGAs/s1600/5-yr%2Bvs%2BCore%2BCPI.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1212" height="225" src="https://2.bp.blogspot.com/-RogqYKl65ro/WleuiQGcj2I/AAAAAAAAXc4/mEfYyjVraoEVVolpAMy556HDszTUyr5LACLcBGAs/s400/5-yr%2Bvs%2BCore%2BCPI.jpg" width="400" /></a></div><br />Chart #10 compares the year over year rate of core CPI inflation and the 5-yr Treasury yield. It suggests that if future inflation averages 2%, as the bond market currently expects, then we might expect the 5-yr Treasury yield to rise from their current level of 2.3% to about 3.5% (with 5-yr real yields on TIPS moving up from their current 0.3% to 1.5%). Those moves are significantly higher than what the bond market is currently expecting. Put another way, the current level of Treasury yields is still unusually low given a 2% inflation world.<br /><br /><div style="text-align: center;">Chart #11</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/--gbveU35wJI/WlexLGoflXI/AAAAAAAAXdA/UsR9sSM6sdgOKNSKQp9DDq02jrKITAnZgCLcBGAs/s1600/10-yr%2Bvs%2BCPI.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1134" height="241" src="https://1.bp.blogspot.com/--gbveU35wJI/WlexLGoflXI/AAAAAAAAXdA/UsR9sSM6sdgOKNSKQp9DDq02jrKITAnZgCLcBGAs/s400/10-yr%2Bvs%2BCPI.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #12</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-ZenJapdKxOk/WlexS0nKDeI/AAAAAAAAXdI/kTE0eEQTQVMpyU8ugd_7zhAOUASoBEyrgCLcBGAs/s1600/Real%2B10-yr%2Byields.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1130" height="241" src="https://3.bp.blogspot.com/-ZenJapdKxOk/WlexS0nKDeI/AAAAAAAAXdI/kTE0eEQTQVMpyU8ugd_7zhAOUASoBEyrgCLcBGAs/s400/Real%2B10-yr%2Byields.jpg" width="400" /></a></div><br />Charts #11 and #12 give you historical context for the relationship between 10-yr Treasury yields and inflation. More often than not, 10-yr yields trade at least 1-2 percentage points higher than the annual rate of inflation. Currently, 10-yr Treasury yields are about 2.5%, whereas the current trend of CPI inflation is about 2%. Were things to get back to "normal," in a 2% inflation world we might therefore expect to see 10-yr yields at 3.5% to 4%.<br /><br />So there is plenty of justification for yields to move higher by much more than the market expects.<br /><br />The only thing keeping yields from rising significantly is the market's belief (as evidenced by 5-yr real yields of only 0.3%) that the economy is still stuck in a "new normal" rut; that due to capacity constraints and demographics, it would be very difficult for the economy to grow by much more than 2% per year for the foreseeable future.<br /><br />This year will prove whether the "new normal" view will prevail, or whether significant tax and regulatory reform will unleash a new wave of growth. My money is on faster growth and higher interest rates. Faster growth will be very welcome, but higher interest rates will hurt, and they could very well keep future equity gains at modest levels (by putting downward pressure on PE ratios) even as the economy improves. So even though the economy looks set to surprise on the upside, it doesn't necessarily follow that equity valuation will also surprise on the upside.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com15tag:blogger.com,1999:blog-6616959642391988608.post-14935441883460251672018-01-09T12:02:00.000-08:002018-01-09T12:02:56.719-08:00Manufacturing is off to a strong startLast week brought the good news that the December ISM manufacturing index exceeded expectations (59.7 vs. 58.2), while the new orders subindex hit a 14-yr high. Some impressive charts:<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-pLXgHQjUFf0/Wk0i8XKMsQI/AAAAAAAAXao/Oje19G9QnVY5Q6voXHEob5ihOPfiDs4rwCLcBGAs/s1600/NAPM%2Bvs%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1226" height="232" src="https://2.bp.blogspot.com/-pLXgHQjUFf0/Wk0i8XKMsQI/AAAAAAAAXao/Oje19G9QnVY5Q6voXHEob5ihOPfiDs4rwCLcBGAs/s400/NAPM%2Bvs%2BGDP.jpg" width="400" /></a></div><br />Chart #1 compares the ISM manufacturing index to quarterly annualized GDP growth. The two tend to move together. As the chart suggests, the recent strength of the manufacturing index is consistent with very strong GDP growth in the fourth quarter. The market is expecting to see something on the order of 3%, but this chart says it could be 4% or better.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-LNAHiqvr8Bo/Wk0jK44RrvI/AAAAAAAAXas/8AkijEAz-MsWSKgGdPF8bEmvErrFVla9QCLcBGAs/s1600/US%2Bvs%2BEurozone%2BMan.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1132" height="241" src="https://2.bp.blogspot.com/-LNAHiqvr8Bo/Wk0jK44RrvI/AAAAAAAAXas/8AkijEAz-MsWSKgGdPF8bEmvErrFVla9QCLcBGAs/s400/US%2Bvs%2BEurozone%2BMan.jpg" width="400" /></a></div><br />Chart #2 compares US manufacturing to that of the Eurozone. Both have been unusually strong of late. It's very likely that the world is in the midst of a relatively strong, synchronized growth phase.<br /><br /><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-4ny6_0btp4Q/Wk0jaO0VWPI/AAAAAAAAXaw/rWokBl1XElQ7wJEcqrqDg5Vcp229DN1rgCLcBGAs/s1600/Screen%2BShot%2B2018-01-03%2Bat%2B10.39.12%2BAM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="1072" data-original-width="1600" height="267" src="https://2.bp.blogspot.com/-4ny6_0btp4Q/Wk0jaO0VWPI/AAAAAAAAXaw/rWokBl1XElQ7wJEcqrqDg5Vcp229DN1rgCLcBGAs/s400/Screen%2BShot%2B2018-01-03%2Bat%2B10.39.12%2BAM.png" width="400" /></a></div><br /><div class="separator" style="clear: both; text-align: left;">Chart #3 shows the New Orders subindex of the ISM manufacturing survey. It's rarely been this strong.&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-M9V-j1abzZg/WlUfP0HJmeI/AAAAAAAAXbM/HwWufB5kp7k0wXx2qHvyJFvKTFMyRDKoQCLcBGAs/s1600/Equity%2Bmkt%2Bcapitalization.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1218" height="225" src="https://3.bp.blogspot.com/-M9V-j1abzZg/WlUfP0HJmeI/AAAAAAAAXbM/HwWufB5kp7k0wXx2qHvyJFvKTFMyRDKoQCLcBGAs/s400/Equity%2Bmkt%2Bcapitalization.jpg" width="400" /></a></div><br />Not surprisingly, equity markets continue to do very well, both here and abroad, as Chart #4 shows.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com5tag:blogger.com,1999:blog-6616959642391988608.post-44669928481797329192017-12-31T17:40:00.000-08:002017-12-31T17:40:43.262-08:00Predictions for 2018One year ago <a href="http://scottgrannis.blogspot.com/2016/12/predictions-for-2017.html">I expected</a> to see an improving economy and further gains in equity prices, and I sure got that right. Stocks are up big-time and GDP growth has accelerated somewhat. But I worried, as I have every year for the past 8 years, that the Fed might be slow to react to rising confidence and declining money demand, and that this could set off a bout of rising inflation. Fortunately, I got that wrong yet again, since inflation has remained in a comfortable 1.5 - 2% range. For the past two years I've liked emerging markets, and they have done quite well. Last year I didn't much care for gold or commodities, but they have done well thanks to a weaker dollar—which I didn't see coming. So it's a mixed bag for calls, but last year's 19.4% rise in equity prices goes a long way to making up for a few smaller losses. In any event, take the following with suitable grains of salt. I've been bullish and right (on stocks) for so long now that it makes even me nervous.<br /><br />All throughout 2017 the world worried that Trump and the Republicans were going to prove incompetent. Was Trump crazy? Could he actually govern? Could the Republicans abolish Obamacare as promised? Could they pass tax reform? Turns out they did a pretty good, if far from perfect, job. Obamacare is being dismantled, beginning with the elimination of the mandate. Tax reform could have been better, but it achieved its main objective: to stimulate investment. Meanwhile, hidden behind the distractions of tweet storms and&nbsp;<i>faux pas</i>, Trump has accomplished a major reduction in federal regulatory burdens. This can really make a difference over the long haul, and it may already be contributing to faster growth.<br /><div><br /></div>Thinking back, Obama in his first year got a $1 trillion dollar stimulus package designed to boot-strap the economy by redistributing income (see my analysis <a href="http://scottgrannis.blogspot.com/2016/11/tracking-trump-with-themes-and-charts.html">here</a>). The result was the slowest recovery on record; Obama ended up borrowing some $8 trillion to no avail, since nothing he did was aimed at increasing the market's desire to invest, work harder, or take risk. Trump in his first year got a $1.5 trillion (CBO-scored "cost") stimulus package designed to boost the economy by increasing the after-tax returns to business investment. <i>I'm betting the results of Trump's tax reform will be much better than expected, but the market is not yet willing to make that same bet, and that is the point of departure for all predictions of what is to come.</i><br /><br />If 2017 was about just one thing, it was the ability of the Republicans to pass meaningful tax reform. The market spent most of the year handicapping the odds of tax reform, and it would appear that it is now mostly, if not fully, priced in. The tax reform package boils down to a one-time 20% boost to after-tax corporate profits (by cutting the corporate income tax rate from 35% to 21%), and that's pretty much what we have seen happen to equity prices this past year.<br /><br />If 2018 is going to be about just one thing, it will be whether boosting the after-tax rewards to business investment results in a stronger economy. Beginning in 2009, Obama and the Democrats gambled that a massive redistribution of income would boost demand and thus boost the economy, but they lost. They ended up <a href="http://scottgrannis.blogspot.com/2016/04/the-bad-news-is-why-im-optimistic.html">flushing $8 trillion down the Keynesian toilet</a>. Trump and the Republicans are now gambling that a significant increase in the after-tax rewards to business investment will boost the economy. Only time will tell, but there are already hints of a stronger economy in the data: e.g., capex is up, industrial production is up, business confidence and the ISM indices are up, and industrial metals prices are up. It's likely that the current quarter could mark the first time we've enjoyed three consecutive quarters of 3% or more growth in over 12 years.<br /><br />I think the meme for 2018 will be this: <i>waiting for GDP</i>. If the economy shows convincing and durable signs of stronger growth, more investment, more jobs, and rising productivity, then the Republicans' gamble will have paid off. If not, the Democrats will have <i>carte blanche</i> to take control of Congress and oust a sitting president.<br /><br />From my supply-sider's perspective, we now have the essential ingredients for a stronger economy in place. Tax incentives are correctly aligned to encourage more business investment; regulatory burdens are being slashed, business confidence is high, and the Fed is not a threat for the foreseeable future. Swap and credit spreads are low, as is implied volatility, and that tells us that liquidity is plentiful and systemic risk is low. The fact that the rest of the world is also doing better as well is just icing on the cake.<br /><br />But, argue the skeptics, won't businesses just use their extra profits to buy back shares and increase their dividends, making the wealthy even wealthier without creating any new jobs? This oft-repeated allegation is an empty argument, because it ignores one key thing: what do those who receive the money from buybacks and dividends do with it? <a href="https://johnhcochrane.blogspot.com/2017/12/the-buyback-fallacy.html#more">John Cochrane explains it</a>&nbsp;in this brief excerpt (do read the whole thing):<br /><br /><blockquote class="tr_bq">Suppose company 1 gets a tax cut, doesn't really know what to do with the money -- on top of all the extra cash the company may already have -- as it doesn't have very good investment projects. It sends the money to shareholders. Well, what do shareholders do with it? (Hint: track the money.) They most likely roll the money in to other investments. They find company 2 that does need the money for investment, and send it to that company. In the end, they only consume it if nobody has any good investment ideas.</blockquote><blockquote class="tr_bq">The larger economic point: In the end, investment in the whole economy has nothing to do with the financial decisions of individual companies. Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.</blockquote><br />In other words, what some companies do with their extra cash is immaterial. What matters is that tax reform has increased the marginal incentive to invest—for the entire economy—by reducing tax rates and by allowing the immediate expensing of capex. On the margin, investment now has become more attractive and more profitable in the US, and this will almost certainly result in more investment (some of which is likely to come from overseas firms deciding to relocate here), which in turn means more jobs, more productivity, and higher real incomes. As I explained a few years ago, <a href="http://scottgrannis.blogspot.com/2016/05/productivity-is-still-missing-ingredient.html">productivity has been the missing ingredient</a> in the current lackluster recovery, and very <a href="http://scottgrannis.blogspot.com/2016/07/the-election-should-be-all-about-growth.html">weak business investment</a> is one reason that productivity has gone missing. A pickup in investment is bound to raise productivity, which is the ultimate driver of growth and prosperity.<br /><br />So it's clear to me that tax reform is a big deal, because it's very likely to boost the long-term growth trajectory of the US economy by a meaningful amount. Surprisingly, however, the market does not appear to share that view. Why else would real yields still be miserably low (e.g., 0.3% for 5-yr TIPS)? Why else would the market expect only a modest increase (0.75% or so) in the Fed's target funds rate for the foreseeable future? The current Fed target is 1.5%, while 2-yr Treasury yields, which are the market's expectation for what that rate will average over the next two years, are only 1.9%. As for real yields, the current Fed target translates into a real yield—using the PCE Core deflator—of roughly zero, while the yield on 5-yr TIPS says the market expects that rate to average only 0.3% over the next 5 years. If the economy really gets up a head of steam (e.g., real growth of 3% or more per year), I can't imagine the Fed wouldn't raise rates by more than the market currently expects, and I can't imagine nominal and real yields in general won't be significantly higher than they are today. The last time the economy was growing at 4% a year (early 2000s), 5-yr TIPS real yields were 3-4%.<br /><br />Yet the Fed is the one thing I worry about, which is nothing new. The Fed has been responsible for every recession in recent memory, because each time they have tightened monetary policy in order to reduce inflation or to ward off an expected increase in inflation, they have ended up choking off growth. They are well aware of this, however, so they are going to be very careful about raising rates as the economy picks up steam. But as I've explained many times before, <a href="http://scottgrannis.blogspot.com/2014/01/this-is-not-fragile-recovery.html">the Fed's worst nightmare</a> is a return of confidence. More confidence in a time of surprisingly strong growth would almost certainly reduce the demand for money; if the Fed doesn't take offsetting moves to increase the demand for all those excess reserves in the banking system (e.g., by raising the funds rate target and draining bank reserves) the result would be an unwelcome rise in inflation. Inflation is a monetary phenomenon: when the supply of money exceeds the demand for it, inflation is the inevitable result. And higher inflation would set us up for the next recession.<br /><br />On balance, I think it's quite likely the economy is going to improve, and surprisingly so. Ordinarily that would be great news for the equity market, since a stronger than expected economy should result in stronger than expected profits. But the market is still cautious, so good news is going to be met with increased skepticism: if the Fed raises rates as the economy improves, the market will worry that higher rates will increase the risk of recession. And even if the Fed is slow to raise rates, the market will see that as a sign that inflation is likely to move higher, and that would in turn increase the odds of more aggressive Fed tightening and eventually another recession. In short, we're probably going to see the market climb periodic <a href="http://scottgrannis.blogspot.com/search?q=walls+of+worry">walls of worry</a>, just as it has for the past several years.<br /><br />Risk assets should do well in this environment, given time, but there will be headwinds. Rising Treasury yields will act to keep PE ratios from rising further, so equity market gains are likely to be driven mainly by stronger-than-expected earnings. At the same &nbsp;time, higher bond yields will make it easier to people to exit stocks (very low yields today make being short stocks very painful).<br /><br />Emerging market economies are so far behind their developed counterparts that they have tremendous upside potential in a world that is increasingly prosperous, but a stronger than expected US economy is likely to boost the dollar, which in turn would put pressure on commodity markets and the emerging economies that depend on them.<br /><br />I continue to believe that gold is trading at a significant premium to its long-term, inflation-adjusted price (which I estimate to be around $600/oz.) because the world is still risk-averse. So a stronger US economy and a stronger dollar would spell bad news for gold. Who needs gold if real yields and real growth are rising?<br /><br />In order to judge whether things are playing out in a healthy fashion, it will be critical to periodically assess the status of the world's demand for money—particularly bank reserves, of which there are over $2 trillion in excess of what is needed for banks to collateralize their deposits. If banks' demand to hold excess reserves declines faster than the Fed's willingness to drain reserves and/or raise the interest rate it pays on reserves, then higher inflation is almost sure to rear its ugly head. Signs of that happening would likely be seen in rising inflation expectations, a falling dollar, a steeper yield curve, and/or rising gold and commodity prices.<br /><br />The world is on the cusp of a new chapter of stronger growth, led by US tax reform. The US economy has plenty of <a href="http://scottgrannis.blogspot.com/2016/10/the-3-trillion-gap.html">upside potential</a>, given the past 8 years of sub-par growth and a significant decline in the labor force participation rate and lingering risk aversion. Tax reform can and should unleash that underutilized potential and boost confidence. The future looks bright, but there are, of course, lots of things that could go wrong (e.g., North Korea, the Middle East, Trump's ego, the Fed) so if and as the world becomes less risk averse, an investor would be wise to remain cautious, since very few things these days are obviously cheap. On the other hand, Treasuries, and bond yields in general, look very low and should thus be approached with great caution.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com21tag:blogger.com,1999:blog-6616959642391988608.post-35906542685763775302017-12-21T11:30:00.000-08:002017-12-21T11:30:15.712-08:00Truck tonnage is impressiveI've been tracking truck tonnage for a long time, and it's been a reliable—and generally bullish—indicator of underlying economic activity. It measures the actual tonnage of freight hauled by the nation's carriers, and this physical measure of the economy's size has also tracked the inflation-adjusted gains of the US equity market. Truck tonnage surged almost 8% in the year ending November, and this is one of the most impressive proofs that economic activity has improved measurably this year.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-5vv_IfDPa-M/WjwGbTh9ZpI/AAAAAAAAXaI/Bm57wNOqofEVU8C525SXFplz6YmzIgQbACLcBGAs/s1600/Truck%2Bvs%2BSP500.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="672" data-original-width="1256" height="216" src="https://4.bp.blogspot.com/-5vv_IfDPa-M/WjwGbTh9ZpI/AAAAAAAAXaI/Bm57wNOqofEVU8C525SXFplz6YmzIgQbACLcBGAs/s400/Truck%2Bvs%2BSP500.jpg" width="400" /></a></div><br />As Chart #1 shows, truck tonnage over time has increased very much in line with the inflation-adjusted increase in equity prices. The latest surge in truck tonnage correlates well with the strength of the stock market this year. If anything, this chart suggests that the equity market is behaving in line with the economic fundamentals and is not, as many fear, in a bubble.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-Kz0yYlCIjXY/WjwHEKb1LAI/AAAAAAAAXaQ/e8_mYSR_xbQ1pvs8vDliXPW5ldtiOdZLwCLcBGAs/s1600/truck%2Btonnage.gif" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="530" data-original-width="736" height="290" src="https://3.bp.blogspot.com/-Kz0yYlCIjXY/WjwHEKb1LAI/AAAAAAAAXaQ/e8_mYSR_xbQ1pvs8vDliXPW5ldtiOdZLwCLcBGAs/s400/truck%2Btonnage.gif" width="400" /></a></div><br />Chart #2 shows a closeup of the past 5 years of the truck tonnage index. The economy appears to have gotten a significant boost starting in the second quarter of this year. As we know now, real GDP growth jumped from 1.2% in the first quarter to 3.1% in the second quarter, and it continued stronger with 3.2% in the third quarter. By all indications, we should see at least 3% growth in the current quarter. It's been 12 years since we have seen three consecutive quarters with 3-handles or better. The economy has really improved this year, and Trump's efforts to reduce regulatory burdens arguably get a significant share of the credit.<br /><br />And the economy should continue to improve next year, as the significant reduction in the corporate income tax rate just passed by Congress spurs more investment, more jobs, and rising real incomes.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com9tag:blogger.com,1999:blog-6616959642391988608.post-85634026155621381572017-12-19T17:27:00.002-08:002017-12-19T17:27:34.277-08:00The bond market begins to figure things out<div style="text-align: left;">For the past year the stock market has had a blast pricing in tax reform. The S&amp;P 500 is now up some 25% or so since the day before the November '16 election, and that gain is only slightly more than the degree to which a cut in the corporate tax rate, from 35% to 21%, causes a one-time rise in after-tax corporate profits. (Here's the equation: (1-.21)/(1-.35) = 21.5%.) The bond market, however, hasn't taken much notice: 10-yr Treasury yields today are 2.45%, only modestly higher than the 2.33% they have averaged over the past year. On the other hand, 5-yr real yields on TIPS (<a href="http://scottgrannis.blogspot.com/2017/06/real-yields-on-tips-are-key-must-watch.html">a key, must-watch indicator</a>&nbsp;as I've argued), today have climbed to 0.37%, which is meaningfully higher than the 0.05% they have averaged over the past year. The rise in bond yields is still modest, but the rise in real yields is better still, since it's the best indicator that the bond market is beginning to price in a stronger economy. And we're still in the early innings. Bond investors, hold on to your hats.</div><br />I first raised this issue—how the stock market was excited about tax reform, but the bond market was ignoring the likely consequences—in a post two weeks ago (<a href="http://scottgrannis.blogspot.com/2017/12/tax-reform-is-priced-in-but-not.html">Tax reform is priced in, but not a stronger economy</a>). It now looks like the bond market is in the early stages of figuring out that a big cut in corporate tax rates is indeed likely to result in an investment boom and a stronger economy in the years to come. The ranks of the Trump despisers have been thinning ever since the summer of 2016, as more and more become convinced he is going to adopt more business- and growth-friendly policies, and the bond market is now beginning to join the party. Yields have just begun what could eventually prove to be a significant move higher, and early signs of that can be found in the slope of the yield curve, which has steepened in recent days.<br /><br /><div class="separator" style="clear: both; text-align: center;"></div><div style="text-align: center;">&nbsp;Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-s-4GDDrrcvw/WjlKpivZRxI/AAAAAAAAXZc/gbAF6i_9Y1c5NWit2I-95_b7Ckwd8HxQwCLcBGAs/s1600/TIPS.gif" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="530" data-original-width="736" height="290" src="https://3.bp.blogspot.com/-s-4GDDrrcvw/WjlKpivZRxI/AAAAAAAAXZc/gbAF6i_9Y1c5NWit2I-95_b7Ckwd8HxQwCLcBGAs/s400/TIPS.gif" width="400" /></a></div><br />Chart #1 shows the slow and gradual uptrend of 5-yr real yields on TIPS. In the past 18 months they have risen by 85 bps, and 70+ bps of that rise has occurred since just before the November '16 election.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-O7uILbe3r54/WjlK3WMWgOI/AAAAAAAAXZk/33ZFAdjzFDkYEB8skSBR8roIVUyDmIojQCLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://1.bp.blogspot.com/-O7uILbe3r54/WjlK3WMWgOI/AAAAAAAAXZk/33ZFAdjzFDkYEB8skSBR8roIVUyDmIojQCLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><br />To be sure, one of the driving forces behind higher real yields is the Fed. Chart #2 shows how the Fed has raised real short-term rates by about 140 bps (from -1.4% just before the '16 elections to about zero now), by increasing its nominal overnight target rate by 1% during a period in which core inflation has fallen from 1.9% to 1.5%. The same chart also shows how the real yield curve has flattened during that same period, as 5-yr real yields (red line) rose by less than overnight real yields. That's again symptomatic of the bond market's reluctance to believe in a stronger economy. (The Fed has shared this belief, and still holds to it, but that is likely to change going forward.)<br /><br /><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-g2TadjE_wMI/WjlLFHqHUYI/AAAAAAAAXZo/oJkOLqawjTUCeJpf51XlStyeoxLhynMeQCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://3.bp.blogspot.com/-g2TadjE_wMI/WjlLFHqHUYI/AAAAAAAAXZo/oJkOLqawjTUCeJpf51XlStyeoxLhynMeQCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #3 shows how real yields on 5-yr TIPS have a strong tendency to track the economy's underlying growth rate. As real growth picks up, real yields are very likely to follow suit. If the economy upshifts from 2% real growth to 3% real growth, as already seems not only possible but likely, real yields are likely to move to 1% or more. Nominal yields will likely rise by about the same amount, assuming inflation expectations remain relatively stable. If we end up with an investment-led boom that delivers 4% real growth, real yields could easily rise to 2-3%, pushing nominal yields on 10-yr Treasuries to 3.5-4.5% or so. Will that kill the economy? No, because <i>higher yields and a stronger economy go hand in hand</i>. We only need to worry about higher yields when the real and nominal yield curves go flat or invert, because that will be a sign that the Fed is too tight. That's not the case today, and the Fed is taking pains to emphasize that it won't move rates up aggressively.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-GXYeSCyiQGY/WjmyHOMZxmI/AAAAAAAAXZ4/Ol--Afk3lDMk1km7rI5l52ag1BqaGGlBACLcBGAs/s1600/YIELD%2BCURVE.gif" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="530" data-original-width="736" height="231" src="https://4.bp.blogspot.com/-GXYeSCyiQGY/WjmyHOMZxmI/AAAAAAAAXZ4/Ol--Afk3lDMk1km7rI5l52ag1BqaGGlBACLcBGAs/s320/YIELD%2BCURVE.gif" width="320" /></a></div><br />Chart #4 shows the evolution of the yield curve from 2 to 10 years (the top panel shows 2- and 10-yr Treasury yields, the bottom panel shows the spread between the two). The curve has flattened substantially since early last July (a sign of the bond market's reluctance to embrace stronger growth), but it has steepened by 8 bps so far this week.<br /><br />Keep an eye on real yields and the slope of the Treasury yield curve. They are excellent barometers of how optimistic the capital markets are about the prospects for stronger economic growth.<br /><br />And don't worry about the impact of higher yields on the economy—at least not until you start to see the yield curve inverting.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com7tag:blogger.com,1999:blog-6616959642391988608.post-64013672633709432232017-12-14T13:53:00.000-08:002017-12-14T13:53:05.829-08:00The Fed is not yet a problemYesterday the FOMC raised its short-term interest rate target to 1.5%, as expected, and indicated that it expects to gradually raise this target to 2.25% over the next year or so. Markets received the news with barely a ripple. Inflation expectations and the value of the dollar haven't budged for months, swap and credit spreads remain quite low, and while the yield curve has flattened in the past few months, it remains reasonably positively-sloped. The market seems to agree with the Fed that it won't need to raise rates by much more than 75 bps for the foreseeable future. We can thus conclude that the Fed and the market are in general agreement about the outlook, and that the outlook calls for only a modest pickup in growth with continued, relatively low and stable inflation.<br /><br />Despite recent and prospective rate hikes, it's important to note that the Fed is not yet "tight," and monetary policy today is probably best described as "neutral." The economy has been picking up a bit of late, optimism is up, and the demand for money consequently is softening. The Fed is correctly offsetting these developments with a minor boost to short-term rates designed to bolster the demand for money.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-xWPXg5ygB2U/WjHYDMN7TEI/AAAAAAAAXWw/rGz5Aqib7H49XrFH3K11ozgeUnmBDKHKgCLcBGAs/s1600/CPI%2BRange%2Bby%2BDecade.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="668" data-original-width="1190" height="225" src="https://2.bp.blogspot.com/-xWPXg5ygB2U/WjHYDMN7TEI/AAAAAAAAXWw/rGz5Aqib7H49XrFH3K11ozgeUnmBDKHKgCLcBGAs/s400/CPI%2BRange%2Bby%2BDecade.jpg" width="400" /></a></div><br />The Fed's record on inflation speaks for itself: for the past 10 years, consumer price inflation has averaged 1.8% with impressively low variance. As Chart #1 shows, the average level, range and variability of CPI inflation in the current decade is lower than in any other decade in the past century. (To read the chart, the red bars show the range of year over year readings in the CPI, The yellow line represents the annualized rate of CPI change over each decade, and the blue bars represent the average plus or minus one standard deviation.) Abstracting from energy prices, which have been extraordinarily volatile in recent decades, the ex-energy CPI has averaged 1.7% in the past year, 1.8% for the past 5 years, 1.8% for the past 10 years, and 2.1% for the past 20 years. On the inflation front, things haven't been this good for generations, and the Fed deserves credit for doing a great job.<br /><br /><div class="separator" style="clear: both; text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-mUvU8BBy40Q/WjHc5hvQJoI/AAAAAAAAXXA/7cK1gRzopsseQ_hLu5d_lFYzBB8CLz-IQCLcBGAs/s1600/Real%2BBroad%2BDollar%2BIndex.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1136" height="241" src="https://4.bp.blogspot.com/-mUvU8BBy40Q/WjHc5hvQJoI/AAAAAAAAXXA/7cK1gRzopsseQ_hLu5d_lFYzBB8CLz-IQCLcBGAs/s400/Real%2BBroad%2BDollar%2BIndex.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: left;">An important part of the Fed's mandate is to maintain the dollar's purchasing power. As Chart #2 shows the dollar today is pretty close to its long-term average against other currencies, after adjusting for inflation. A relatively stable dollar vis a vis other currencies is one important way to ensure the dollar maintains its overall purchasing power.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-q3BkYH1rR5Q/WjLHC9mQ9mI/AAAAAAAAXXQ/8i-rr1NjHUErW7CwMgoYDbU5_EUIi7vBgCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://4.bp.blogspot.com/-q3BkYH1rR5Q/WjLHC9mQ9mI/AAAAAAAAXXQ/8i-rr1NjHUErW7CwMgoYDbU5_EUIi7vBgCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Chart #3 shows, the market's expectation for inflation over the next 5 years is currently 1.8%. That is just about exactly the prevailing rate of inflation in recent years, and very much in line with historical experience. Although some worry that this is below the Fed's "target" of 2%, I think most economists and consumers would prefer 1.8% to 2%.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-zN-_z_LMTvs/WjLH-6cpvwI/AAAAAAAAXXY/7j4cAOh8jYksy5nSWqad_yW-1VbDNIzmQCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://1.bp.blogspot.com/-zN-_z_LMTvs/WjLH-6cpvwI/AAAAAAAAXXY/7j4cAOh8jYksy5nSWqad_yW-1VbDNIzmQCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Chart #4 shows, the real yield on 5-yr TIPS has a strong tendency to track the economy's underlying trend rate of growth, for which I use the 2-yr annualized change in real GDP. Real yields have been rising slowly and very gradually in recent years, suggesting the market is pricing in a modest increase in real growth. Real growth has averaged about 2.2% per year for most of the current recovery, but the market now seems to be pricing in something in the range of 2.5-2.8% growth over the next year. That also happens to be in line with the FOMC's forecasts. I note also that the Atlanta Fed is now projecting 3.3% annualized growth for the current quarter, which would result in a 2.7% annual rate of growth for the current year.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">This is encouraging, of course, but as I <a href="http://scottgrannis.blogspot.com/2017/12/tax-reform-is-priced-in-but-not.html">argued</a> last week, the market is not yet pricing in a significant boost to growth from the pending tax reform package.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-t6SIHWG4McI/WjLKV6zetQI/AAAAAAAAXXk/xKSEnEg8HrMNyiHvJK4HUyyCJgNVxxFgACLcBGAs/s1600/2-yr%2BSwaps%2B89.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1134" height="241" src="https://4.bp.blogspot.com/-t6SIHWG4McI/WjLKV6zetQI/AAAAAAAAXXk/xKSEnEg8HrMNyiHvJK4HUyyCJgNVxxFgACLcBGAs/s400/2-yr%2BSwaps%2B89.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Chart #5 shows, 2-yr swap spreads are quite low. This strongly suggests that market liquidity conditions are excellent, systemic risk is low, and the economic fundamentals are generally rather healthy. That's not surprising, actually, since the Fed has yet to withdraw a significant amount of bank reserves from the system, as it did in prior tightening cycles.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #6</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-1rjpZFqKJM0/WjLLVTrdqkI/AAAAAAAAXXs/gX26ueuCIW8xZjJO6ke_cd7zG1Cw-jyzwCLcBGAs/s1600/CDS%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1260" height="216" src="https://4.bp.blogspot.com/-1rjpZFqKJM0/WjLLVTrdqkI/AAAAAAAAXXs/gX26ueuCIW8xZjJO6ke_cd7zG1Cw-jyzwCLcBGAs/s400/CDS%2Bspreads.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Chart #6 shows, Credit Default Swap Spreads are also quite low. These instruments are very liquid, and are excellent proxies for short- to medium-term credit risk in the corporate bond market. Conditions look pretty good right now.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #7</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-WSkNJnxYe9M/WjLMDFMfniI/AAAAAAAAXX4/r8xxHdWlB_8XIjq4JzMZFqE7nI1OHTdVgCLcBGAs/s1600/IG%2Bvs%2BHY%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="694" data-original-width="1198" height="232" src="https://3.bp.blogspot.com/-WSkNJnxYe9M/WjLMDFMfniI/AAAAAAAAXX4/r8xxHdWlB_8XIjq4JzMZFqE7nI1OHTdVgCLcBGAs/s400/IG%2Bvs%2BHY%2Bspreads.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #7 tells the same story by showing indices of credit spreads in the broad market for corporate bonds of investment grade and high-yield ratings. The market has a good deal of confidence in the outlook for the economy.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #8</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-i2AajWE8Jhk/WjLNVhHPXoI/AAAAAAAAXYE/mVwpAVNhM2AuapeJUnrT1RNCnPNzQWpdwCEwYBhgL/s1600/Real%2BFFs%2Bvs%2Bslope.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="660" data-original-width="1098" height="241" src="https://3.bp.blogspot.com/-i2AajWE8Jhk/WjLNVhHPXoI/AAAAAAAAXYE/mVwpAVNhM2AuapeJUnrT1RNCnPNzQWpdwCEwYBhgL/s400/Real%2BFFs%2Bvs%2Bslope.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Chart #8 shows, all postwar recessions have been preceded by a significant tightening of monetary policy (as evidenced by a sharp rise in the real Fed funds rate) and a flattening of the yield curve (as evidence by a negatively-sloped Treasury curve). Currently, inflation-adjusted short-term rates are close to zero, which is hardly punitive. And while the yield curve has flattened substantially, it is still reasonably positive. Taken together, these two conditions suggest that the Fed is at least a year or two away from delivering monetary policy tight enough to begin to hobble the economy.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #9</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-70ndYpheeB4/WjLQDDnxxGI/AAAAAAAAXYc/qkr6SjdDEOgqBgdLEzWod8apSF-h49LAwCLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://2.bp.blogspot.com/-70ndYpheeB4/WjLQDDnxxGI/AAAAAAAAXYc/qkr6SjdDEOgqBgdLEzWod8apSF-h49LAwCLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #9 focuses on the outlook for the real yield curve (which also has inverted prior to past recessions), by comparing the current real funds rate (blue) to what the market expects that real rate to average over the next 5 years (red). Although the real yield curve is rather flat, it is not inverted, and real yields are not projected to be very high. Indeed, both the Fed and the market expect that the Fed funds rate will be increased only modestly, in line with a modest pickup in real growth.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #10</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-bIld4C1J8GY/WjLO99ZoozI/AAAAAAAAXYQ/KGr7PG-Yys4E98Qsvyo8xYFrYhynFbcAgCLcBGAs/s1600/Yields%2Band%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="722" data-original-width="1214" height="240" src="https://1.bp.blogspot.com/-bIld4C1J8GY/WjLO99ZoozI/AAAAAAAAXYQ/KGr7PG-Yys4E98Qsvyo8xYFrYhynFbcAgCLcBGAs/s400/Yields%2Band%2Bspreads.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #10 shows a big-picture view of the nominal Treasury yield curve, as represented by 2- and 10-yr Treasury yields and the spread between the two. I note that the current spread (54 bps) is about the same as we saw in the mid-1990s, when the economy was quite healthy.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #11</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-9DZaCL8iUJY/WjLtpqE3sqI/AAAAAAAAXYs/NA1fTfzxHtUeTeT7Y2b0AzhYhk2-4MFiACLcBGAs/s1600/Savings%2Bdeposits.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1128" height="241" src="https://2.bp.blogspot.com/-9DZaCL8iUJY/WjLtpqE3sqI/AAAAAAAAXYs/NA1fTfzxHtUeTeT7Y2b0AzhYhk2-4MFiACLcBGAs/s400/Savings%2Bdeposits.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #12</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-LJ0QCsTjFAo/WjLtrJrdlFI/AAAAAAAAXYw/GJEkm35uu24wRsxL89wbfXTHVESVC49qQCLcBGAs/s1600/Savings%2Bdeposit%2Bgrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1162" height="228" src="https://1.bp.blogspot.com/-LJ0QCsTjFAo/WjLtrJrdlFI/AAAAAAAAXYw/GJEkm35uu24wRsxL89wbfXTHVESVC49qQCLcBGAs/s400/Savings%2Bdeposit%2Bgrowth.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Charts #11 and #12 show, over the past year there has been a significant slowdown in the growth of bank savings deposits. I take this as a sign that the demand for money has dropped meaningfully. Savings deposits have paid almost nothing in the way of interest, but demand for them was incredibly strong in the years following the Great Recession. The appeal of savings deposit was not their yield, but their safety. Now, even though they are yielding more than zero, demand for them has dropped. People are no longer so interested in safety. It's not surprising that equities have done very well for the past year; as the public has attempted to pare its holdings of cash in favor of riskier assets, the price of cash has risen and the yield on equities has declined (i.e., short-term rates have increased as equity yields have decreased). The Fed would be irresponsible to not raise rates given this important shift in the demand for money.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #13</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-c9w7zCrc95g/WjLvJhAGnTI/AAAAAAAAXY8/35JAZnjMWKkwK8Vv-Y8mpVarbdGQdDvXgCLcBGAs/s1600/Conference%2BBoard.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="660" data-original-width="1150" height="228" src="https://1.bp.blogspot.com/-c9w7zCrc95g/WjLvJhAGnTI/AAAAAAAAXY8/35JAZnjMWKkwK8Vv-Y8mpVarbdGQdDvXgCLcBGAs/s400/Conference%2BBoard.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #14</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-aJd8fT4XhHk/WjLvOE2XuII/AAAAAAAAXZA/JKL09KUMQBYM0hklnAOljKgeZfTi9SQpgCLcBGAs/s1600/Small%2Bbusiness%2Boptimism.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1112" height="245" src="https://3.bp.blogspot.com/-aJd8fT4XhHk/WjLvOE2XuII/AAAAAAAAXZA/JKL09KUMQBYM0hklnAOljKgeZfTi9SQpgCLcBGAs/s400/Small%2Bbusiness%2Boptimism.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Charts #13 and #14 show, there has been a significant increase in confidence in the past year, both among consumers and small business owners. This increase in confidence is fully consistent with the slowdown in the growth of savings deposits. On the margin, people are deciding to put money to work rather than stashing it away in banks.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #15</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-y1THBvDqKOc/WjLv823CtQI/AAAAAAAAXZI/rDotQbVahyMG8ybonJ2CqiuNJ_VnHwjvQCLcBGAs/s1600/Money%2BDemand.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="672" data-original-width="1152" height="232" src="https://1.bp.blogspot.com/-y1THBvDqKOc/WjLv823CtQI/AAAAAAAAXZI/rDotQbVahyMG8ybonJ2CqiuNJ_VnHwjvQCLcBGAs/s400/Money%2BDemand.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">The counterpart to a slowdown in the demand for money is an increase in the velocity of money. Chart #15 illustrates how we may have seen the peak in money demand. Going forward, even if the supply of money in the economy grows at a slower pace, rising velocity should ensure that nominal, and perhaps also real GDP growth, should pick up. We are seeing that already in Q3 and Q4 GDP, and it should continue, especially if tax reform passes.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;"><b>Conclusion</b>: If tax reform passes in anything like its current form, the economy is quite likely to pick up by more than the market and the Fed are expecting. That's because tax reform will directly increase the incentives to invest, and that in turn means more jobs, more productivity, and higher wages. This also implies that 10-yr Treasury yields are going to have to rise by more than the market currently expects, if only because real yields should rise as the economy's real growth potential increases. Tax reform thus spells very bad news for the long end of the Treasury market. However, it's also true that rising market yields could (and should) put downward pressure on equity multiples. Thus, even though the economy strengthens and corporate profits increase, the rise in equity prices going forward could be modest rather than meteoric.&nbsp;</div>Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com12tag:blogger.com,1999:blog-6616959642391988608.post-38855349102762154092017-12-08T09:35:00.002-08:002017-12-12T07:49:05.819-08:00No jobs boom yet, but...The November jobs data were slightly better than expected (+221K vs. +195K), but from a big-picture perspective, jobs growth remains at best moderate. Private sector jobs, the ones that count, are increasing at a 1.6-1.7% annual rate, as they have been for most of the past year. Ho-hum. However, small business optimism looks strong, particularly in regard to future hiring plans. Small businesses are almost sure to be the main engine of jobs growth going forward, so this is very good news.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-VjtagbQV_sg/WirKaTYGj7I/AAAAAAAAXWA/Rso6Hz43zSAOIuInElq-_dL2hnT0hXmiQCLcBGAs/s1600/Monthly%2BChange%2B97-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1150" height="236" src="https://2.bp.blogspot.com/-VjtagbQV_sg/WirKaTYGj7I/AAAAAAAAXWA/Rso6Hz43zSAOIuInElq-_dL2hnT0hXmiQCLcBGAs/s400/Monthly%2BChange%2B97-.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: center;">&nbsp;Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-15_ANxDq-Jg/WirKluPQJVI/AAAAAAAAXWE/NooAbWA32QUSp3bpIRooqM-PXk1chUXZwCLcBGAs/s1600/Private%2BSector%2BJobs%2BGrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1130" height="241" src="https://3.bp.blogspot.com/-15_ANxDq-Jg/WirKluPQJVI/AAAAAAAAXWE/NooAbWA32QUSp3bpIRooqM-PXk1chUXZwCLcBGAs/s400/Private%2BSector%2BJobs%2BGrowth.jpg" width="400" /> </a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As Charts #1 and #2 show, there hasn't been any change in the underlying rate of growth of private sector jobs for most of the past year. Indeed, the pace of hiring this year has been slower than it was in prior years.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div style="text-align: center;">&nbsp;Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-HykdwDRpgCw/WirK-ztwm4I/AAAAAAAAXWM/u7OriMcM2GE2-uojaKnDfl3qk4YSFzyrQCLcBGAs/s1600/Small%2Bbusiness%2Bhiring.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1138" height="240" src="https://4.bp.blogspot.com/-HykdwDRpgCw/WirK-ztwm4I/AAAAAAAAXWM/u7OriMcM2GE2-uojaKnDfl3qk4YSFzyrQCLcBGAs/s400/Small%2Bbusiness%2Bhiring.jpg" width="400" />&nbsp;</a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">However, there has been a significant improvement among small business owners, as Chart #3 shows. An index of future hiring plans in November posted its strongest reading in the 44-year history of the survey. This suggests that Trump's efforts to reduce regulatory burdens, coupled with a strong expectation of reduced future tax burdens, have already produced positive results.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As I mentioned earlier this week, though, <a href="http://scottgrannis.blogspot.com/2017/12/tax-reform-is-priced-in-but-not.html">the market has still not priced in a stronger economy</a>. Optimism is building, but the market is still in a "show-me" frame of mind. </div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">UPDATE: Today (Dec. 12, '17) the overall Small Business Optimism Index was released, and it was also impressive, surging to a level that is just shy of that which occurred at the dawn of the boom years which followed the Reagan tax cuts:</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-52t2E4R5k68/Wi_6POsD9qI/AAAAAAAAXWg/JcrrlL_yL2sIgsvj8FAqzoe7EmIdCQaFQCLcBGAs/s1600/Small%2Bbusiness%2Boptimism.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1112" height="245" src="https://4.bp.blogspot.com/-52t2E4R5k68/Wi_6POsD9qI/AAAAAAAAXWg/JcrrlL_yL2sIgsvj8FAqzoe7EmIdCQaFQCLcBGAs/s400/Small%2Bbusiness%2Boptimism.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><br />Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com3tag:blogger.com,1999:blog-6616959642391988608.post-83390648347129936702017-12-07T11:27:00.000-08:002017-12-07T11:27:59.332-08:00Wealthier and wealthierToday the Fed released its quarterly estimate of household net worth. Things just keep getting better and better. Household net worth as of Sept. 30 was almost $97 trillion, having risen $7.2 trillion over the past year (+8%). As in recent years, gains have come mostly from financial assets (up $18 trillion since late 2007), plus real estate (up $2.4 trillion since the peak of 2006), offset by only a minor increase in debt (total liabilities rose from $14.5 trillion in 2008 to $15.4 trillion). Further details in the charts below:<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-6jPmntDLFS0/WimQL8VDA5I/AAAAAAAAXVE/dRFWE4t5UXQ79PVBtdqyHs2gzw4eDF_UACLcBGAs/s1600/Households%2BBalance%2BSheet.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1286" height="220" src="https://1.bp.blogspot.com/-6jPmntDLFS0/WimQL8VDA5I/AAAAAAAAXVE/dRFWE4t5UXQ79PVBtdqyHs2gzw4eDF_UACLcBGAs/s400/Households%2BBalance%2BSheet.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #1 summarizes the evolution of household net worth.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-ZlW9Ujc2XHU/WimQTat2MlI/AAAAAAAAXVI/iwv___YvioYeQvGbYPF4TxIbtWqrH4PvACLcBGAs/s1600/Real%2Bnet%2Bworth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="674" data-original-width="1134" height="240" src="https://3.bp.blogspot.com/-ZlW9Ujc2XHU/WimQTat2MlI/AAAAAAAAXVI/iwv___YvioYeQvGbYPF4TxIbtWqrH4PvACLcBGAs/s400/Real%2Bnet%2Bworth.jpg" width="400" /></a></div><br />Chart #2 shows the long-term trend of real net worth, which has risen on average by about 3.5% per year over the past 65 years. Is this a great country, or what? I note also that recent levels of net worth do not appear to have diverged at all from long-term trends. That wasn't the case in 2007 however, when stocks were in what we now know was a valuation "bubble."<br /><br /><div style="text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-J5OQs2bIB_M/WimQa_8BpEI/AAAAAAAAXVM/IfDIq0X717sglAECDSo1QXyaqDXLG84kgCLcBGAs/s1600/Real%2Bper%2Bcap%2Bnet%2Bworth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="676" data-original-width="1150" height="233" src="https://1.bp.blogspot.com/-J5OQs2bIB_M/WimQa_8BpEI/AAAAAAAAXVM/IfDIq0X717sglAECDSo1QXyaqDXLG84kgCLcBGAs/s400/Real%2Bper%2Bcap%2Bnet%2Bworth.jpg" width="400" /></a></div><br />Chart #3 shows real net worth per capita. The average person in the U.S. today is worth almost $300,000, and that figure has been increasing on average by about 2.3% per year for the past 67 years. Regardless of who owns the country's wealth, everyone benefits from the infrastructure, the equipment, the computers, the offices, the homes, the factories, the research facilities, the workers, the teachers, the families, and the brains that sit in homes and offices all over the country and arrange the affairs of the nation so as to produce almost $20 trillion of income per year.<br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-7d4dRpQpdms/WimQi7DCnDI/AAAAAAAAXVQ/l5cgI67fpo8FYHA2XW-26bSJic-B-pr6QCLcBGAs/s1600/Household%2Bleverage.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="676" data-original-width="1140" height="236" src="https://4.bp.blogspot.com/-7d4dRpQpdms/WimQi7DCnDI/AAAAAAAAXVQ/l5cgI67fpo8FYHA2XW-26bSJic-B-pr6QCLcBGAs/s400/Household%2Bleverage.jpg" width="400" /></a></div><br />Chart #4 shows that households have been extremely prudent in managing their financial affairs since the Great Recession. Household leverage (total debt as a % of total assets) has declined by fully one-third since its Q1/09 high. Leverage is now back to the levels which prevailed during the boom times of the mid-80s and 90s. Of course, while households were busy strengthening their finances, the federal government was doing just the opposite: the burden of federal debt more than doubled from June '08 to September '17 (i.e., federal debt owed to the public rose from 35% of GDP to 75% of GDP).Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com0tag:blogger.com,1999:blog-6616959642391988608.post-92064168855639127452017-12-05T14:55:00.000-08:002017-12-06T08:34:35.835-08:00Tax reform is priced in, but not a stronger economyThe S&amp;P 500 keeps setting new record highs, we're on the cusp of a major tax reform, and the economy is showing signs of perking up. Pessimists fret that we're in another bubble that could pop at any moment, while optimists believe the economy has lots of upside potential. I'm still in the latter camp, though I do acknowledge that it's tough to find much that is cheap these days. In any event, what the market seems to be ignoring is that the kind of tax cuts we're about to experience—which are unprecedented in their focus on businesses—are very likely to lead to a business investment boom, and that in turn is likely to result in more jobs, more productivity, and higher wages and salaries in the years to come.<br /><br />The S&amp;P 500 is up about 24% since the week before Trump won last year's election. Half of that gain is due to increased earnings on continuing operations, while the other half is due to a rise in the multiple the market is willing to pay for a dollar's worth of those earnings (i.e., PE ratios). Over that same period,&nbsp; 5-yr Treasury yields have jumped by about 80 bps (from 1.3% to 2.4%), and real yields on 5-yr TIPS have jumped 65 bps (from -0.33% to +0.33%), implying a meaningful increase in real growth expectations but only a modest rise in inflation expectations.<br /><br />Both the bond and the stock market have thus undergone some significant price adjustments that are consistent with an improved economic outlook. Investors expect more growth (as seen in rising real yields) and rising after-tax profits (as evidenced by higher PE ratios). So: is the market now pricing in an economic boom because of the likely passage of Trump's tax reform? Or is the market just pricing in the boost to future after-tax earnings that would result from a sizeable reduction in corporate income taxes (from 35% to 20%)? The way I read the market tea leaves, the market has little doubt that tax reform will pass, and that it will in turn boost after-tax corporate profits. But as yet I see no convincing evidence that the market is pricing in a substantial increase in economic growth rates—almost certainly not of the magnitude which the Republicans are touting (i.e., 3% or more). So we're faced with a mixed bag of market expectations: good news for profits and equity investors, but not much reason to cheer for the man on the street. That's missing the forest for the trees.<br /><br />Outside of the Republican booster community and supply-side economists, I see very few who expect real GDP growth to rise significantly in coming years. Left-leaning commentators argue that the tax reform being pushed is very unlikely to do anything outside of lining the pockets of big business and the wealthy. A recent Bloomberg article, "<a href="https://www.bloomberg.com/view/articles/2017-08-01/supply-siders-still-push-what-doesn-t-work">Supply-Siders Still Push What Doesn't Work</a>" argues that what has really been holding growth back is not high taxes and heavy regulatory burdens, it's an aging population that is still nursing the wounds to confidence it suffered in the Great Recession of 2008-09. It's not hard to deploy statistics in a way that bolsters your argument, as the Bloomberg article does, but there are some facts in the historical record which should be incontestable: the tax cuts that occurred during the Reagan and Clinton eras boosted economic growth considerably, while the massive fiscal spending "stimulus" of the Obama years failed miserably. (see charts below) <br /><br />As I <a href="http://scottgrannis.blogspot.com/2016/11/tracking-trump-with-themes-and-charts.html">argued</a> a year ago, the only good thing about the American Recovery and Reinvestment Act of 2009 was that it served as a laboratory experiment to test the value of the government spending multiplier. ARRA boosters argued that it would kick-start the recovery and deliver strong growth for years to come. Unfortunately, the results were the exact opposite of what was expected by the Keynesians. Why? Because the ARRA was all about income redistribution. It did nothing to change the incentives to work and invest:<br /><blockquote><br />Fully 63% of the "stimulus" spending was income redistribution in disguise (i.e., tax benefits and entitlements). And if you reclassify things such as education, housing assistance, and health as transfer payments, then over 75% of the $840 billion allocated to "stimulus" was essentially income redistribution. Only 8%—$65.5 billion—went for transportation and infrastructure (i.e., the "shovel-ready" projects that would put American back to work). Not a dime went to increase anyone's incentive to work harder or invest more.</blockquote><blockquote class="tr_bq">The ARRA was a laboratory experiment in the power of the government spending multiplier to grow the economy by "stimulating demand." It ended up proving that the multiplier is way less than one. American taxpayers borrowed $840 billion only to learn that the payoff was only a small fraction of the additional debt incurred. We wasted almost a trillion dollars of the economy's scarce resources, and that's a big reason why the recovery has been so disappointing. If we had instead "spent" the money on lowering tax rates for everyone (e.g., we could have eliminated corporate taxes for three years with the ARRA money spent) in order to give them a greater incentive to work and invest, the results could have been dramatically better. The tax cuts might even have paid for themselves in the form of a stronger recovery over time.</blockquote><br />Income redistribution does nothing to change the long-term growth path of the economy. It takes investment, risk-taking, and working harder and more effectively to boost growth. Incurring debt to finance spending is a waste of the economy's resources, but incurring debt to finance productive investment can lead to a real payoff. Indeed, that was the lesson we learned from the ARRA: excessive spending financed by debt can weaken the economy.<br /><br />The principle virtue of the Tax Cuts and Jobs Act about to be passed by Congress is that it significantly increases the after-tax rewards to business investment by slashing corporate income tax rates and by allowing immediate expensing of capital investments. This automatically lowers the hurdle rate for all investment projects, and thus it should lead to a significant increase in investment, jobs, and incomes over time. The TCJA&nbsp; has its faults, unfortunately, and these center on measures which produce only one-time gains in after-tax income (e.g., increases in the standard deduction and the child credit which do nothing to reward new investment, harder work, or risk-taking). But on balance it is very pro-growth.<br /><br />The TCJA differs importantly from the Reagan tax cuts in the early 1980s, since the latter focused almost exclusively on lowering individual income tax rates. Reagan gambled that cutting tax rates on individuals would eventually lead to a stronger economy since everyone would have an incentive to work harder and invest more. But by focusing directly on the investment side of the economy, the TCJA could prove even more effective than the Reagan tax cuts.<br /><br />The charts that follow illustrate the various ways in which the economy is already perking up, and they also illustrate why I think the market has yet to price in a stronger economy as a result of the passage of the TCJA.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-_AsPIRpdp8k/Wib6DMtd6zI/AAAAAAAAXSo/eXD8sa7BJ9oj6DnM-20DkH6vuHcd2V0GwCLcBGAs/s1600/Global%2BInd%2BProduction.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1118" height="243" src="https://1.bp.blogspot.com/-_AsPIRpdp8k/Wib6DMtd6zI/AAAAAAAAXSo/eXD8sa7BJ9oj6DnM-20DkH6vuHcd2V0GwCLcBGAs/s400/Global%2BInd%2BProduction.jpg" width="400" /></a></div><br /><div style="text-align: center;">&nbsp;Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-b19cHQmBFB4/Wib6KZTVZ0I/AAAAAAAAXSs/K55FP4JCgp8IXvTHp5az6u9TImx4tio1QCLcBGAs/s1600/US%2BManufacturing%2BProd.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1130" height="240" src="https://2.bp.blogspot.com/-b19cHQmBFB4/Wib6KZTVZ0I/AAAAAAAAXSs/K55FP4JCgp8IXvTHp5az6u9TImx4tio1QCLcBGAs/s400/US%2BManufacturing%2BProd.jpg" width="400" /></a></div><br />Charts #1 and #2 illustrate the substantial recent upturn in US industrial &amp; manufacturing production, and how that has been accompanied by a significant pickup in Eurozone industrial production. We're seeing a coordinated acceleration in global manufacturing and output, which is a nice tailwind to enjoy.<br /><br /><div style="text-align: center;">Chart #3 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-nmYKtnfAGLU/Wib6efbd-pI/AAAAAAAAXSw/OhPOTzaVxK49FnWPpDeeH0WBwgXx7NobgCLcBGAs/s1600/Housing%2BStarts.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="688" data-original-width="1212" height="226" src="https://2.bp.blogspot.com/-nmYKtnfAGLU/Wib6efbd-pI/AAAAAAAAXSw/OhPOTzaVxK49FnWPpDeeH0WBwgXx7NobgCLcBGAs/s400/Housing%2BStarts.jpg" width="400" /></a></div><br />Chart #3 suggests that housing starts have lots of upside potential, especially considering the strong levels of builder sentiment. By eliminating or limiting the mortgage interest deduction (which subsidizes housing and thus makes housing more expensive than otherwise), the TCJA could make housing more affordable for the middle class and thus stimulate more housing supply. A dramatic increase in the standard deduction would render the loss of the mortgage deduction moot for a whole swath of the population. <br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-ZVqKhMnHrOI/Wib8SZENlII/AAAAAAAAXS8/T3be5vXVWEM_EvQYaQVFVywWzJVMhT04ACLcBGAs/s1600/NAPM%2Bvs%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1226" height="231" src="https://3.bp.blogspot.com/-ZVqKhMnHrOI/Wib8SZENlII/AAAAAAAAXS8/T3be5vXVWEM_EvQYaQVFVywWzJVMhT04ACLcBGAs/s400/NAPM%2Bvs%2BGDP.jpg" width="400" /></a></div><br />As Chart #4 suggests, the ISM manufacturing report is consistent with GDP growth exceeding 3% in the third quarter. The Atlanta Fed's GDPNow index currently predicts fourth quarter real growth of 3.2%. That would put real growth for the year at over 2.7%, which is comfortably above the 2.2% annualized growth rate of the current business cycle expansion. This is very encouraging.<br /><br /><div style="text-align: center;">Chart #5 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-rQ9gnVWuh_k/Wib9NLYTTHI/AAAAAAAAXTI/cRqBylk1mlQBff4hdxmuWCW-5TsQ5GluwCLcBGAs/s1600/C%2526I%2BLoans%2B99-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1140" height="238" src="https://1.bp.blogspot.com/-rQ9gnVWuh_k/Wib9NLYTTHI/AAAAAAAAXTI/cRqBylk1mlQBff4hdxmuWCW-5TsQ5GluwCLcBGAs/s400/C%2526I%2BLoans%2B99-.jpg" width="400" /></a></div>&nbsp; <br /><div style="text-align: center;">Chart #6 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-jI5oxlV9yig/Wib9f5L_ZNI/AAAAAAAAXTM/DZGzjjX_R_kN8r2g9ICSSDH249rRd8ztQCLcBGAs/s1600/All%2Bloans%2Bleases%2Bdelinq%2Brate.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1092" height="250" src="https://4.bp.blogspot.com/-jI5oxlV9yig/Wib9f5L_ZNI/AAAAAAAAXTM/DZGzjjX_R_kN8r2g9ICSSDH249rRd8ztQCLcBGAs/s400/All%2Bloans%2Bleases%2Bdelinq%2Brate.jpg" width="400" /></a></div><br />Chart #5 shows a substantial recent slowdown in the growth of Commercial &amp; Industrial Loans (a proxy for bank lending to small and medium-sized businesses). Ordinarily, this would be disturbing since it could be the result of a severe tightening in lending standards. But as Chart #6 shows, banks have little reason to tighten lending standards since delinquency rates on all loans and leases are at record lows. This suggests that the slowdown in lending reflects caution on the part of business borrowers, and that is not necessarily a bad thing. Relative to GDP, C&amp;I Loans are about as high as they have ever been.<br /><br /><div style="text-align: center;">Chart #7 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-A8XA2sfYnZE/Wib97q-g7LI/AAAAAAAAXTU/_OPriVFLVyksPLpLjuxFwDDDLtKYD6KYgCLcBGAs/s1600/Profits%2B%2525%2Bof%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1148" height="235" src="https://1.bp.blogspot.com/-A8XA2sfYnZE/Wib97q-g7LI/AAAAAAAAXTU/_OPriVFLVyksPLpLjuxFwDDDLtKYD6KYgCLcBGAs/s400/Profits%2B%2525%2Bof%2BGDP.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #8 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-4dHM_bZ128g/Wib-EjrfvwI/AAAAAAAAXTY/KH5l3DOXYvEIUHRgzhn3vwKdzmm4yQiDQCLcBGAs/s1600/NIPA%2BPE%2BRatio.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1118" height="242" src="https://3.bp.blogspot.com/-4dHM_bZ128g/Wib-EjrfvwI/AAAAAAAAXTY/KH5l3DOXYvEIUHRgzhn3vwKdzmm4yQiDQCLcBGAs/s400/NIPA%2BPE%2BRatio.jpg" width="400" /></a></div><br />Chart #7 illustrates the incredible and lasting strength of corporate profits over the past decade. Chart #8 uses this measure of profits (derived from income tax data supplied by businesses to the IRS and compiled into the National Income and Product Accounts) to show that current PE ratios are not excessive by historical standards. Yes, PE ratios are above average, but profits have been way above average for a long time, so the market is not necessarily in bubble territory. I wrote more extensively on this issue <a href="http://scottgrannis.blogspot.com/2017/09/a-better-pe-ratio.html">here</a>.<br /><br /><div style="text-align: center;">Chart #9 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-vCoH3BOwJvY/WicFdYRIKtI/AAAAAAAAXUI/hpVEdBgvw4ACZtil_3aCbZ9uxAQW77YgwCLcBGAs/s1600/Real%2BGDP%2B2-yr.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1126" height="240" src="https://2.bp.blogspot.com/-vCoH3BOwJvY/WicFdYRIKtI/AAAAAAAAXUI/hpVEdBgvw4ACZtil_3aCbZ9uxAQW77YgwCLcBGAs/s400/Real%2BGDP%2B2-yr.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #10 </div><div class="separator" style="clear: both; text-align: center;"><img border="0" data-original-height="780" data-original-width="1244" height="250" src="https://4.bp.blogspot.com/-NzDoegSFeHQ/WicGXndKj4I/AAAAAAAAXUQ/uZLHPe2N_2Y_BGNpnxelVbei5ALdXVw6ACLcBGAs/s400/Capgains%2Btax%2Band%2Brevs.jpg" width="400" /></div><br />Chart #9 looks at the 2-yr annualized growth rate of GDP since 1970. I use this measure in order to smooth out the typically volatile nature of this series on a quarterly and annual basis. It should be easy to see how strong growth was during the mid- to late-1980s, following the Reagan tax cuts. It also illustrates the impressive strength of the economy in the late 1990s, during which time the capital gains tax rate was cut. Chart #10 illustrates how sensitive capital gains tax collections are to changes in the capital gains tax rate. Capgains realizations surged in advance of the big hike in the capgains rate in late 1986, and surged again as the rate was cut during the late 1990s. Lower tax rates can indeed boost tax revenues, while the threat of higher rates can crush tax revenues. <br /><br /><div style="text-align: center;">Chart #11</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-MweouHapLi0/Wib-VJHKbYI/AAAAAAAAXTc/5nsEBktLkL0GeE6EYczPglcRwryOgpejQCLcBGAs/s1600/Equity%2Brisk%2Bpremium.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1126" height="240" src="https://4.bp.blogspot.com/-MweouHapLi0/Wib-VJHKbYI/AAAAAAAAXTc/5nsEBktLkL0GeE6EYczPglcRwryOgpejQCLcBGAs/s400/Equity%2Brisk%2Bpremium.jpg" width="400" /></a></div><br />It is noteworthy that the current equity risk premium, illustrated in Chart #11, has remained relatively high in recent years. This suggests investors have been very reluctant to price in a stronger economy. Risk premiums were much lower in the boom years of the 80s and 90s.<br /><br /><div style="text-align: center;">Chart #12 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-9CAHbQd2R7E/Wib-nbSYSkI/AAAAAAAAXTk/88BaIVRfqPcqMD9PNnL1xn2Yb6bpeHLOwCLcBGAs/s1600/Fixed%2BInvstmnt%2Bvs%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="662" data-original-width="1142" height="231" src="https://1.bp.blogspot.com/-9CAHbQd2R7E/Wib-nbSYSkI/AAAAAAAAXTk/88BaIVRfqPcqMD9PNnL1xn2Yb6bpeHLOwCLcBGAs/s400/Fixed%2BInvstmnt%2Bvs%2BGDP.jpg" width="400" /></a></div><br />Chart #12 shows how weak business investment has been in the past decade, despite the extraordinary level of corporate profits shown in Chart #7. A dearth of business investment has been at the root of the economys sluggish performance over the past decade. That is why the TCJA, which boosts incentives for business investment, could be so important—it directly addresses the problem that has plagued the economy for years. And by lowering business income tax rates here relative to other countries, it could act as a magnet for international capital flows.<br /><br /><div style="text-align: center;">Chart #13 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-wSlGojxUV3M/WicIBFvAFDI/AAAAAAAAXUc/wADuko9NpkksE4UKsKDEyt-kVL6PKgSkgCLcBGAs/s1600/5-yr%2Bproductivity.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1124" height="241" src="https://2.bp.blogspot.com/-wSlGojxUV3M/WicIBFvAFDI/AAAAAAAAXUc/wADuko9NpkksE4UKsKDEyt-kVL6PKgSkgCLcBGAs/s400/5-yr%2Bproductivity.jpg" width="400" /></a></div><br />Chart #13 shows the 5-yr annualized growth in productivity, highlighted by presidential terms. The Bloomberg article cited above showed the annual growth in output per hour on a year over year basis. This measure of productivity is naturally volatile, so measuring it over longer periods makes it easier to see the big trends. Output per hour isn't the same total labor productivity, however, which is shown in Chart #13, and in any event changes in productivity are one thing while growth in the overall economy (which includes productivity and the number and hours of people working) is another. Regardless, the very weak growth of GDP and productivity in the Obama years is pretty good proof that the policies pursued during the Obama years were not conducive to growth or prosperity. The second half of the Clinton years, in contrast, rank right up there with the Reagan years, all of which featured tax rate reductions. <br /><br /><div style="text-align: center;">Chart #14</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-aHKgqagTojg/Wib-zgElf4I/AAAAAAAAXTo/0gdQzbjBYBY5ICV6bM_V0D8hFhmYqUJhACLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://3.bp.blogspot.com/-aHKgqagTojg/Wib-zgElf4I/AAAAAAAAXTo/0gdQzbjBYBY5ICV6bM_V0D8hFhmYqUJhACLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a></div><br />Chart #14 shows nominal and real rates on 5-yr Treasuries, plus the difference between the two, which is the market's expectation for consumer price inflation over the subsequent five years. Inflation expectations haven't changed much in the past few decades, and currently average about 1.8% per year for the foreseeable future, which is very much in line with what inflation has averaged in recent decades.<br /><br /><div style="text-align: center;">Chart #15 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-yn9wQSM0KGI/Wib-6xb7ZnI/AAAAAAAAXTs/krP4G2W5C5cfJNCQWrliJn1XzMtPx2TVgCLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://2.bp.blogspot.com/-yn9wQSM0KGI/Wib-6xb7ZnI/AAAAAAAAXTs/krP4G2W5C5cfJNCQWrliJn1XzMtPx2TVgCLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><br />Chart #15 compares the real yield on 5-yr TIPS (red line) with the real Fed funds rate (the Fed's target for overnight rates minus the rate of inflation as measured by the PCE Core deflator). Think of the red line as the market's expectation for what the blue line will average over the next 5 years. Note that the real yield curve inverted (i.e., the blue line exceeded the red line) prior to each of the past two recessions. That happens when the Fed becomes so tight that the economy begins to weaken and the market begins to assume that the Fed will be cutting rates in the future. Currently, the real yield curve is still positively sloped. If anything stands out here, it is the market's belief that the Fed is going raise rates only a few more times in the years to come. If the economy picks up steam, however, the Fed is going to be raising rates by a lot more than that. <br /><br /><div style="text-align: center;">Chart #16 </div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-duyUrX--tas/Wib_HVUwgfI/AAAAAAAAXT0/ehq0ymqEaPs16vOXM3CxdMGP3iGDtj_sgCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="221" src="https://2.bp.blogspot.com/-duyUrX--tas/Wib_HVUwgfI/AAAAAAAAXT0/ehq0ymqEaPs16vOXM3CxdMGP3iGDtj_sgCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><br />As Chart #16 shows, the level of real yields on TIPS (blue line) tends to track the economy's real rate of growth over time. That's only logical, since very high real yields can hardly be generated by a weakly-growing economy, whereas a strongly-growing economy, such as we had in the late 1990s, can produce very positive real yields on a variety of asset classes. The current level of real yields in the bond market is consistent with real economic growth rates that are roughly 2%, which is what we've seen over the recent business cycle expansion. If real growth rates were to ratchet up to 3% or more per year, I would bet lots of money that real yields on TIPS would rise to at least 1-2%. With stable inflation expectations, that would imply 5-yr Treasury yields of almost 3-4%, substantially higher than the current 2.2% rate on 5-yr Treasuries. Bond investors need to brace for sharply higher yields if I'm right about the impact of the TCJA.<br /><br /><div style="text-align: center;">Chart #17</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-LuL0jPoVugc/Wib_hHiGHSI/AAAAAAAAXT4/94YzLpKS_0MKj5XZTtYsZtOltwkekWtEwCLcBGAs/s1600/5-yr%2Bvs%2BCore%2BCPI.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1212" height="225" src="https://2.bp.blogspot.com/-LuL0jPoVugc/Wib_hHiGHSI/AAAAAAAAXT4/94YzLpKS_0MKj5XZTtYsZtOltwkekWtEwCLcBGAs/s400/5-yr%2Bvs%2BCore%2BCPI.jpg" width="400" />&nbsp;</a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Chart #17 suggests that nominal yields on 5-yr Treasuries are unusually low given the current level of core inflation. This reinforces the fact that stronger real economic growth would necessarily lead to substantially higher nominal Treasury yields.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">As should be obvious from the last two charts, Treasury yields are quite low compared to where they would probably trade if the economy were to prove much stronger than currently expected as a result of tax reform.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">To sum up: the rally in equity prices is evidence that the market is pricing in the passage of tax reform. But the continued low level of real and nominal Treasury yields is evidence that the market has yet to price in the stronger economic growth that is likely to result from tax reform.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">UPDATE: I'm adding my chart of GDP growth vs its long-term trend in order to give some broader context to this discussion, and to add to some discussion of the subject of "potential" GDP in the comments section.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-maA3BpBO6qc/WigcBq1JNkI/AAAAAAAAXU0/8YkfEJQgwW4fYfDzad_nisC6FVPrTxWTwCLcBGAs/s1600/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1142" height="240" src="https://4.bp.blogspot.com/-maA3BpBO6qc/WigcBq1JNkI/AAAAAAAAXU0/8YkfEJQgwW4fYfDzad_nisC6FVPrTxWTwCLcBGAs/s400/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><br />Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com25tag:blogger.com,1999:blog-6616959642391988608.post-73818881657597930112017-11-16T22:34:00.000-08:002017-11-16T23:43:02.290-08:00AAPL still looks goodI've been a fan of Apple's ever since I bought the stock about 15 years ago. I've had a number of <a href="http://scottgrannis.blogspot.com/search?q=apple">posts</a> on Apple over the years, all of which have been bullish. I'm still optimistic about Apple's prospects, even as it approaches the $1 trillion capitalization mark.<br /><br />I got my new iPhone X a few days ago, and it is by far the most beautiful and exciting of all the iPhones I've ever had (and I've owned every model they've made). Face ID is surprisingly fast and seamless (and accurate!), the display is much larger and a pleasure to look at, the build quality is superb, the battery life is much longer, the camera is <i>much</i> better, and the gestures that replace the home button are powerful and easy to use, not to mention it's wicked fast. It costs more than its predecessor (iPhone 8), but it delivers much more at the same time. Since my digital life revolves around this little jewel, I'm happy to pay extra, and I'm sure tens of millions of others will feel the same way. Apple can no longer be accused of not innovating. Its flagship product has leapfrogged the competition, and it's become the "apple" of everyone's eye.<br /><br />The iPhone X is going to set sales records. Face ID is almost surely coming to Apple's entire product line over the next year, and that will very likely trigger a wave of upgrades. But the market, believe it or not, is still not convinced that Apple's best days lie ahead. Apple's cash-adjusted PE ratio today is less than 17, giving it an earnings yield of 6%. That implies, in my judgment, that the market still suspects Apple will have a hard time increasing earnings. If expectations were solidly behind continued earnings gains, Apple's PE ratio would be a lot higher. Following are some nifty charts which tell the story.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-Htcd5mdM9ho/Wg4YBENybFI/AAAAAAAAXRw/DIAlcPTOo1op6yNRG9Jti-i0nlEjbdzzQCLcBGAs/s1600/Apple.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1134" height="241" src="https://2.bp.blogspot.com/-Htcd5mdM9ho/Wg4YBENybFI/AAAAAAAAXRw/DIAlcPTOo1op6yNRG9Jti-i0nlEjbdzzQCLcBGAs/s400/Apple.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: left;">Wow. One of the Great American Success Stories, told in one chart. (Note the y-axis is done with a semi-log scale.)</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-EMVd72FHoWw/Wg4YYUeYU8I/AAAAAAAAXR4/NulFKkBVhBECdT2lgirqcED3CYxp6Kv-ACLcBGAs/s1600/AAPL%2BPE.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1184" height="228" src="https://1.bp.blogspot.com/-EMVd72FHoWw/Wg4YYUeYU8I/AAAAAAAAXR4/NulFKkBVhBECdT2lgirqcED3CYxp6Kv-ACLcBGAs/s400/AAPL%2BPE.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">If the market were wildly optimistic about Apple, it would be tough to recommend the stock. But as the chart above shows, Apple's PE ratio has been below 20 for the past seven years, even as its stock price as more than quadrupled. As I've suggested in my prior posts, the market has consistently under-appreciated Apple's ability to grow. And that still looks to be the case, with the S&amp;P 500 trading at a PE of just under 22 (using earnings from continuing operations), and Apple's PE trading at more than a 10% discount to that. If you adjust for the mountain of cash that Apple has sitting offshore, Apple's PE ratio is trading at almost a 25% discount to the broad market.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-5Ygf7Frw_eU/Wg4YSmCcxoI/AAAAAAAAXR0/nOdsldeLbdIKhz--Wtd5kZiSM61F4h5LQCLcBGAs/s1600/AAPL%2BEPS.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1144" height="236" src="https://4.bp.blogspot.com/-5Ygf7Frw_eU/Wg4YSmCcxoI/AAAAAAAAXR0/nOdsldeLbdIKhz--Wtd5kZiSM61F4h5LQCLcBGAs/s400/AAPL%2BEPS.jpg" width="400" /></a></div><br />As the chart above shows, Apple's earnings haven't grown nearly as fast in recent years as its stock price. In the past 5 years, earnings per share have grown over 45%, while the stock price has more than doubled. The way I see it, the market has become a lot less pessimistic about Apple's prospects in the past 5 years, which is why Apple's PE ratio has increased from a meager 10 in early 2013. But the market is still cautious.<br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-OJtIErCqDzM/Wg4Z-aiPRaI/AAAAAAAAXSE/9Y5C2LEh0koAcj6VoEwqq_z3IzKleKqYgCLcBGAs/s1600/AAPL%2Bvs%2BMSFT.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="708" data-original-width="1154" height="245" src="https://3.bp.blogspot.com/-OJtIErCqDzM/Wg4Z-aiPRaI/AAAAAAAAXSE/9Y5C2LEh0koAcj6VoEwqq_z3IzKleKqYgCLcBGAs/s400/AAPL%2Bvs%2BMSFT.jpg" width="400" /></a></div><br />Is a $1 trillion capitalization reasonable? Apple is not outrageously priced compared to other companies, as Chart #4 shows. Microsoft today is only $250 billion behind Apple's current market cap, and most of what MSFT sells is software and services. This chart is a great David vs. Goliath story, with once-tiny Apple leapfrogging its gigantic former rival. 20 years ago the market thought MSFT would control the entire PC market within a few years. Today Apple has made tremendous gains, but they still don't have a majority of smartphone sales, nor a majority of PC sales. There's plenty of room for Apple to grow.<br /><br /><div style="text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-Ag7OynrKe_4/Wg4iD3hz85I/AAAAAAAAXSU/BUcYchu8F5oYl6q_S3MyGai60Ulf-TJ_ACLcBGAs/s1600/CPI%2BPersonal%2BComputers.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="714" data-original-width="1170" height="243" src="https://3.bp.blogspot.com/-Ag7OynrKe_4/Wg4iD3hz85I/AAAAAAAAXSU/BUcYchu8F5oYl6q_S3MyGai60Ulf-TJ_ACLcBGAs/s400/CPI%2BPersonal%2BComputers.jpg" width="400" /></a></div><br />One final note: I could be wrong, but it strikes me that Apple has set an important precedent with the pricing of iPhone X. Prior to this, Apple (and most of its competitors) routinely brought out better, faster, and more capable products for the same price as what was being replaced; customers were thus getting more and more power and features for the same price. Now, for the first time, a hi-tech computer product has come out that is not only better but more expensive. Apple has demonstrated pricing power in an industry that has suffered from 20 years of deflation. You can see that in Chart #5 above.<br /><br />The BLS uses what is called "hedonic pricing" to calculate that personal computer and peripherals have effectively fallen continuously over the past 20 years—if you get more of something for the same price as before, its price has effectively fallen. The index in the chart has fallen by more than 96% over the past 20 years. But it should also be apparent that the rate of decline has been slowing ever since the early 00s. In the initial heydays of PCs, prices fell 35% a year; then 20% per year; then 10% per year. In the past 12 months, prices have fallen by a mere 3.3%. The pricing and the success of the iPhone X may be among the first signs that in coming years you can expect to pay more in order to get more when it comes to computers.<br /><br />Full disclosure: I am long AAPL at the time of this writing, and have no plans to sell in the near future.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com11tag:blogger.com,1999:blog-6616959642391988608.post-69219939975971972322017-11-15T18:58:00.001-08:002017-12-06T08:30:51.033-08:00The yield curve is not a red flagIn the past week or so I've see more and more people worrying about the flattening of the Treasury yield curve. I've also seen breathless stories about how the nation's malls are emptying, subprime auto loan defaults are surging, and student loans are defaulting. While these are all disturbing developments, a lot of other things will need to happen before the economy is at risk of falling into another recession. In that regard, I note that credit spreads are still relatively low, swap spreads are very low, real yields are very low, inflation and inflation expectations are right where they should be, and the financial system has tons of liquidity.<br /><br />The following charts put some meat on my argument, and all contain the most up-to-date data available as of today.<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-sSCLOQhRbWE/WgzvjXMG95I/AAAAAAAAXQw/9aMgW69Vc_YRaYf6fDfKkTlrub_Kq9xeQCLcBGAs/s1600/Financial%2BConditions.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="818" data-original-width="1110" height="293" src="https://4.bp.blogspot.com/-sSCLOQhRbWE/WgzvjXMG95I/AAAAAAAAXQw/9aMgW69Vc_YRaYf6fDfKkTlrub_Kq9xeQCLcBGAs/s400/Financial%2BConditions.jpg" width="400" /></a></div><br />The first chart sums it all up: it's Bloomberg's index of all the factors that contribute to financial market conditions. By this measure, financial conditions are about as good as they get. The following charts drill down into these factors to see how they stack up and what they mean.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-8N_O1wElY_U/WgzvtnbVMLI/AAAAAAAAXQ0/WZwbxtNcHAs9nySb0FunhRJxe_rxnChPACLcBGAs/s1600/Real%2BFFs%2Bvs%2Bslope.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="660" data-original-width="1098" height="241" src="https://4.bp.blogspot.com/-8N_O1wElY_U/WgzvtnbVMLI/AAAAAAAAXQ0/WZwbxtNcHAs9nySb0FunhRJxe_rxnChPACLcBGAs/s400/Real%2BFFs%2Bvs%2Bslope.jpg" width="400" /></a></div><br />The chart above is one of my favorites. It shows that two things have preceded every recession since 1960: real interest rates (blue line) have risen sharply, and the Treasury yield curve has gone flat or inverted (red line). That's another way of saying that the Fed has been the proximate cause of every recession in modern times. They have tightened monetary policy to such an extent that the economy just couldn't take it anymore. Until 2008, when Quantitative Easing started, the Fed tightened policy by withdrawing bank reserves from the financial system. Banks need reserves to back up their deposits, so when reserves become scarce they must pay more to get the reserves they need: this pushes up short-term interest rates. It also results in a general scarcity or shortage of liquidity. Rising rates and tighter liquidity conditions start eroding the economy's underpinnings. The economic and financial fundamentals deteriorate until people are forced to sell and panic ensues.<br /><div style="text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: center;">Chart #3</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-adT4xoDxVjM/Wgzw5_RdVHI/AAAAAAAAXRQ/LaYtv1p-oOcutOcV4vRQ4k0Q0kZkOhAnwCLcBGAs/s1600/Excess%2Breserves.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="716" data-original-width="1128" height="253" src="https://3.bp.blogspot.com/-adT4xoDxVjM/Wgzw5_RdVHI/AAAAAAAAXRQ/LaYtv1p-oOcutOcV4vRQ4k0Q0kZkOhAnwCLcBGAs/s400/Excess%2Breserves.jpg" width="400" /></a></div><br />This time around, however, things are VERY different. Because of Quantitative Easing, the Fed can't tighten like they used to. They can't even begin to make bank reserves scarce enough to forces short-term rates higher. As Chart #3 shows, there are about $2 trillion of excess reserves in the system: way more than banks need to back up their deposits. The Fed gets around this by paying interest on reserves, which it never did before. In the old days banks always wanted to minimize their reserve holdings because they paid no interest. Nowadays banks don't worry so much, because reserves pay interest that is close to what T-bills pay; reserves are an asset today, whereas they were a deadweight loss before. By increasing the rate it pays on reserves, the Fed directly impacts all short-term interest rates without there being any shortage of liquidty.<br /><br />So this tightening cycle that we are now in will be very different from past tightening cycles, because it will be a long time (years) before the banking system approaches the point at which bank reserves become scarce—the Fed is going to unwinding its balance <i>very slowly</i>. The Fed can "tighten" by raising short-term interest rates, but they can't create a shortage of liquidity like they did before. So it's not surprising that despite higher short-term interest rates and a flattening of the yield curve, there is as yet no sign that financial market conditions are deteriorating, as the following charts demonstrate.<br /><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-hSSJvkYnwnQ/WgzwcI2Ql1I/AAAAAAAAXRE/vXSW-Til0eQOx_I1-z7cXVfFwUtnVc3fACLcBGAs/s1600/Yields%2Band%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="722" data-original-width="1214" height="240" src="https://2.bp.blogspot.com/-hSSJvkYnwnQ/WgzwcI2Ql1I/AAAAAAAAXRE/vXSW-Til0eQOx_I1-z7cXVfFwUtnVc3fACLcBGAs/s400/Yields%2Band%2Bspreads.jpg" width="400" /></a></div><br />Chart #4 shows the 40-year history of the Treasury yield curve. The bottom two lines show the yields on 2- and 10-yr Treasuries, while the top line (blue) shows the difference between the two (i.e., the slope of the yield curve). Here we see that flatter and inverted curves are always the result of short-term interest rates rising by more than long-term interest rates. That's the Fed in action. We also see that the yield curve can be fairly flat, as it is today, for many years before a recession hits (e.g., the mid-90s). To really squeeze the economy, you need not only a flat curve but much higher interest rates and a shortage of liquidity.<br /><br /><div style="text-align: center;">Chart #5</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-oWqtek6sW4A/Wgzv7vHQkXI/AAAAAAAAXQ4/obFI4foA6isCJhcRlB_ZIQA-fxpp-xEuACLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://3.bp.blogspot.com/-oWqtek6sW4A/Wgzv7vHQkXI/AAAAAAAAXQ4/obFI4foA6isCJhcRlB_ZIQA-fxpp-xEuACLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><div><br /></div><div>Chart #5 shows the real yield curve in action. Real yields are the true measure of how high or low interest rates are. A 10% yield in a 10% inflation environment is not a big deal, but a 10% yield in a 2% inflation environment is a killer. The blue line is the Fed's real short-term interest rate target. Currently it is about zero, or it will be next month, when the Fed will almost surely announce that the rate it pays on reserves will rise to 1.5%. That's just a tiny bit less than the underlying rate of inflation (1.6%), according to the PCE core deflator, which is the Fed's preferred measure of inflation. (PCE Core inflation is typically about 30 to 40 bps less than CPI inflation.)</div><div><br /></div><div>As the chart also shows, the front end of the real yield curve is pretty flat. What that means is that the market doesn't expect the Fed to tighten much more after the December meeting. The 5-yr real yield on TIPS is effectively the markets' expectation for what the real Fed funds rate will average over the next 5 years. Note that prior to the last two recessions the real yield curve inverted: the blue line rose above the red line. That meant that the market expected the Fed to start lowering interest rates in the foreseeable future, because the market sensed that monetary conditions were beginning to undermine the economy's fundamentals. That's not the case today.</div><div><br /></div><div style="text-align: center;">Chart #6</div><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-LMlBVQQJ1S0/Wgzwuf05GRI/AAAAAAAAXRM/9A_DGaj0iGgQURcjdcB95_eHpHNyBE8LQCLcBGAs/s1600/2-yr%2BSwaps%2B89.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1134" height="241" src="https://3.bp.blogspot.com/-LMlBVQQJ1S0/Wgzwuf05GRI/AAAAAAAAXRM/9A_DGaj0iGgQURcjdcB95_eHpHNyBE8LQCLcBGAs/s400/2-yr%2BSwaps%2B89.jpg" width="400" /></a></div><br />2-yr swap spreads are among my most favorite indicators, because they have been good leading indicators of economic conditions. In normal times, swap spreads are 10-30 basis points. Today they are 18 bps. Just about perfect. That means that liquidity is abundant and systemic risk is low. The financial markets are not worried at all about widespread defaults or a liquidity squeeze. The Fed hasn't tightened at all, by this measure.<br /><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: center;">Chart #7&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-Fx9k7qiQFdY/WgzxGHRJ4kI/AAAAAAAAXRU/H-G2xB87mv0Vm5iYOWPra5JFrayiMEZFACLcBGAs/s1600/CDS%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1260" height="216" src="https://2.bp.blogspot.com/-Fx9k7qiQFdY/WgzxGHRJ4kI/AAAAAAAAXRU/H-G2xB87mv0Vm5iYOWPra5JFrayiMEZFACLcBGAs/s400/CDS%2Bspreads.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #8</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-6AgWjxGZVHs/WgzxQEzzVYI/AAAAAAAAXRc/0WvlbAYf-Jc2jJRnJ7jq0YjwvUYO_u0bQCLcBGAs/s1600/IG%2Bvs%2BHY%2Bspreads.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="698" data-original-width="1186" height="235" src="https://4.bp.blogspot.com/-6AgWjxGZVHs/WgzxQEzzVYI/AAAAAAAAXRc/0WvlbAYf-Jc2jJRnJ7jq0YjwvUYO_u0bQCLcBGAs/s400/IG%2Bvs%2BHY%2Bspreads.jpg" width="400" /></a></div><br />As charts 7 and 8 show, credit spreads are fairly low. Despite the news of defaults in certain sectors of the economy, investors by and large are not worried much about widespread defaults. This also tells us that the Fed hasn't really tightened at all. Corporations can borrow as much as they want without having to pay onerous interest rates.<br /><br /><div style="text-align: center;">Chart #9</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-pEBDoMjgNaA/WgzxdEsiFuI/AAAAAAAAXRg/W4ymc1vOy0gZ-Q1wdQ8DdGtUu9xi3SSbgCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://2.bp.blogspot.com/-pEBDoMjgNaA/WgzxdEsiFuI/AAAAAAAAXRg/W4ymc1vOy0gZ-Q1wdQ8DdGtUu9xi3SSbgCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a></div><br />Finally, Chart #9 shows that the market's expectation for consumer price inflation over the next 5 years is 1.85%, just a bit shy of the Fed's professed target of 2%. That's plenty good enough for government work, as they say. The Fed has delivered 2% CPI inflation (annualized) for the past 20 years, and the market fully expects more of the same. Nobody is worried that the Fed is going to have to tighten unexpectedly.<br /><br />Until we see the yield curve actually invert, until we see real yields move substantially higher, until we see swap and credit spreads moving significantly higher, and until inflation expectations move significantly higher, a recession is very unlikely for the foreseeable future.<br /><br />UPDATE: I'm adding my oft-used chart that shows the "Obama Gap," which illustrates how dismal the economy's rate of growth has been over the past 8 years, compared to what it was for the previous 40+ years. You'll find some discussion of this subject in the comments section if you're interested.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-lAFr8-HRiDg/WigbI6NRtVI/AAAAAAAAXUs/CeF0-fh9OLgCZCu1Q21KEVHtkhGuiAcRwCLcBGAs/s1600/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1142" height="240" src="https://3.bp.blogspot.com/-lAFr8-HRiDg/WigbI6NRtVI/AAAAAAAAXUs/CeF0-fh9OLgCZCu1Q21KEVHtkhGuiAcRwCLcBGAs/s400/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" width="400" /></a></div><br />Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com11tag:blogger.com,1999:blog-6616959642391988608.post-18208854676521904922017-11-13T17:59:00.000-08:002017-11-13T22:55:01.073-08:00Delaying tax cuts is ballooning the deficitTrust politicians to do the opposite of what they should do. The overriding problem that is keeping Congress from achieving true, growth-friendly tax reform is concern that lower tax rates would mean a larger budget deficit. Consequently, politicians are trying to "pay for" lowering some taxes by raising others and/or reducing allowable deductions. Instead, they should be focusing on the urgent need to cut taxes in order to reduce the deficit and strengthen the economy.<br /><br />I discussed this in greater detail in a post last month (<a href="http://scottgrannis.blogspot.com/2017/10/not-cutting-tax-rates-is-boosting.html">Not cutting tax rates is boosting the deficit</a>). Here's the short version of the story: Since February 2016, when there first emerged a growing consensus that the corporate income tax rate was too high and needed to be cut, revenues from corporate and individual income taxes have flatlined, while federal spending has continued to increase. As a result, the deficit has jumped from $405 billion to $683 billion. The logical explanation for the huge shortfall in revenues (despite the fact that tax rates have not fallen and income and profits have continued to increase at healthy rates) is that people and companies have been actively engaged in minimizing their tax liabilities by deferring income, not realizing capital gains, postponing investments, and accelerating deductions. Why? Because there is a reasonable chance that by doing so they will be able to take advantage of lower tax rates in the future. By inference, this strongly suggests that if Congress manages to cut tax rates, then federal revenues will surge and the deficit will decline, and the economy will benefit from increased investment, spurred by lower corporate income tax rates and increased business investment.<br /><br />Here are some updated charts which fill in the story:<br /><br /><div style="text-align: center;">Chart #1</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-SX2HH14EQUo/WgogJGY_zuI/AAAAAAAAXQM/LEQx47b-KwYP4RYqqHgx9juNyc3a707zwCLcBGAs/s1600/Receipts%2Band%2BOutlays.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1112" height="243" src="https://4.bp.blogspot.com/-SX2HH14EQUo/WgogJGY_zuI/AAAAAAAAXQM/LEQx47b-KwYP4RYqqHgx9juNyc3a707zwCLcBGAs/s400/Receipts%2Band%2BOutlays.jpg" width="400" /></a></div><br />Spending has been rising at a 4-5% annual rate for the past several years. Revenues, however, have gone flat since Feb. 2016. This is notable, because since then, personal incomes and corporate profits have continued to rise, and there has been no cut in anyone's tax rate. A static forecasting model would have projected continued increases in income tax revenues.<br /><br /><div style="text-align: center;">Chart #2</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-BqqQ6AMDFT4/WgogROwhQBI/AAAAAAAAXQQ/FfSfggwktK4S8cPvLepsXRjJmzw2huf8wCLcBGAs/s1600/Federal%2BRevenues.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="714" data-original-width="1142" height="250" src="https://2.bp.blogspot.com/-BqqQ6AMDFT4/WgogROwhQBI/AAAAAAAAXQQ/FfSfggwktK4S8cPvLepsXRjJmzw2huf8wCLcBGAs/s400/Federal%2BRevenues.jpg" width="400" /></a></div><br />The revenue shortfall can be traced to the individual and corporate income taxes. Together, these two important sources of federal revenue have been flat to slightly down since Feb. 2016. Meanwhile, payroll taxes have been increasing at a steady 5% annual rate, which is exactly in line with wages, incomes, and higher contribution limits. Payroll taxes are very difficult to avoid or postpone.<br /><br /><div style="text-align: center;">Chart #3</div><div style="text-align: center;"><a href="https://3.bp.blogspot.com/-1zieQZavoHw/WgoggKP54oI/AAAAAAAAXQY/P5P0mFt2gwMO9jdDU3-OQadirHn09FAeQCLcBGAs/s1600/Spending%2Bvs%2BRevs%2B%2525%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1158" height="233" src="https://3.bp.blogspot.com/-1zieQZavoHw/WgoggKP54oI/AAAAAAAAXQY/P5P0mFt2gwMO9jdDU3-OQadirHn09FAeQCLcBGAs/s400/Spending%2Bvs%2BRevs%2B%2525%2BGDP.jpg" width="400" /></a></div><br /><div style="text-align: center;">Chart #4</div><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-1K5L20STbPI/WgogXUKz6hI/AAAAAAAAXQU/FgZDV7mWasMQmauYESkMLIrbmh8C6oMPACLcBGAs/s1600/Deficit%2B%2525%2Bof%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="662" data-original-width="1152" height="228" src="https://2.bp.blogspot.com/-1K5L20STbPI/WgogXUKz6hI/AAAAAAAAXQU/FgZDV7mWasMQmauYESkMLIrbmh8C6oMPACLcBGAs/s400/Deficit%2B%2525%2Bof%2BGDP.jpg" width="400" /></a></div><br />As a percent of GDP, federal spending and revenues are not terribly out of line with historical norms, as Chart #3 suggests. As Chart #4 shows, the federal budget deficit is not out of the range of what we experienced from the mid-70s to the mid-80s.<br /><br /><div class="separator" style="clear: both; text-align: center;">Chart #5&nbsp;</div><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-KeGOPrQjvRg/WgogrCbS62I/AAAAAAAAXQg/2RECvMU_bHUHsbY9spZZd4fckwyKxhHfgCLcBGAs/s1600/Budget%2Bdeficit-surplus.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="712" data-original-width="1152" height="248" src="https://4.bp.blogspot.com/-KeGOPrQjvRg/WgogrCbS62I/AAAAAAAAXQg/2RECvMU_bHUHsbY9spZZd4fckwyKxhHfgCLcBGAs/s400/Budget%2Bdeficit-surplus.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: left;">In nominal dollar terms, today's budget deficit has grown from $405 billion in the 12 months ended Feb. 2016 to $683 billion in the 12 months ended Oct. 2017. That's an increase of $278 billion, or 68%. At this rate it is going to be a problem fairly soon. Bear in mind, however, that the main driver of the increase in the deficit is the unusually slow growth (especially given that the economy has been growing) in corporate and individual income tax revenues. This could improve quite rapidly if tax rates on corporate and individual incomes are reduced in a meaningful fashion.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">People and businesses respond to incentives; that is at the heart of all economic analysis (or at least it should be, but the CBO unfortunately refuses to believe it). Since the chances of lower tax rates are appreciably greater than zero, people and businesses have an incentive to minimize their tax liabilities, and the unusually slow growth of federal revenues supports this thesis. If Congress keeps dragging its feet on this issue, or if a cut in corporate taxes is postponed until 2019 (as the Senate is stupidly proposing), then the deficit is going to get worse, investments are going to be postponed, and the economy is likely to weaken.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">The weakness in federal revenues is also a good indication that tax rates on businesses and individuals are too high. The fact that US corporations have avoided repatriating as much as $3 trillion in overseas profits is very strong evidence that corporate income taxes are too high. As my mentor Art Laffer taught me, tax rates that affect behavior in inefficient and uneconomic ways are by definition too high. The best tax rate is the one that people are content to pay, and are least likely to avoid paying. We all know that taxes are a fact of life. But when the marginal rate on corporate profits is 35-40%, and the marginal rate on individual income is 50-65% (as is the case today, including state taxes), taxes are obviously too high, because evasion is high (because the rewards to tax evasion are huge), and revenues are low.</div>Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com12tag:blogger.com,1999:blog-6616959642391988608.post-29507073458815867832017-11-04T13:06:00.000-07:002017-11-04T13:06:00.461-07:00Jobs growth is disappointing, but the tax plan is encouragingMonthly jobs data are by nature volatile, and they can be revised significantly for up to two years, so you can't give one or even several months of numbers much importance. I like to track the trend in jobs growth over 6- to 12-month periods, since the monthly volatility tends to wash out. By that standard, private sector jobs growth has slowed from 2.5% three years ago to about 1.5% now, and shows no sign of improving despite lots of good news from the stock market. If it weren't for a modest uptick in labor productivity (which has picked up from a low of -0.4% in the year ending June 2016 to 1.5% in the year ending last September), the economy would not be keeping pace with the 2.2% annualized growth rate that it has experienced since the recovery began in mid-2009 (in the year ended last September, the economy registered only 2.26% growth). In effect, a recent, modest increase in productivity—which remains miserably low—is offsetting a slowdown in jobs growth, and the result is continued sluggish growth. Things could be worse, but it's hard to reconcile the ebullience of the stock market with the weak pace of hiring.<br /><br />To be sure, GDP growth has averaged about 3% in the past two quarters, and there is reason to believe it could could be at least 3% in the current quarter. But until we see a credible increase in the pace of hiring, it is premature to expect a sustained and/or impressive increase in overall growth. That most likely will require successful tax reform. But in the meantime, there are still several encouraging indicators which suggest that the economy is unlikely to enter a recession for the foreseeable future: business investment has picked up a bit, the ISM surveys show impressive results, and real yields are increasing (but only very gradually). Details can be found in the following charts.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-AQq12U8YOaY/Wf0987MouYI/AAAAAAAAXPA/t2wjgEgEFZAy7EY-k9UEPPqKmUFLtfYggCLcBGAs/s1600/Monthly%2BChange%2B97-.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1150" height="236" src="https://4.bp.blogspot.com/-AQq12U8YOaY/Wf0987MouYI/AAAAAAAAXPA/t2wjgEgEFZAy7EY-k9UEPPqKmUFLtfYggCLcBGAs/s400/Monthly%2BChange%2B97-.jpg" width="400" /></a></div><br />The chart above shows the monthly change in private sector jobs. I focus on the private sector, since that is the economy's engine of growth. As the green line suggests, there hasn't been any sustained improvement in the pace of jobs creation for a long time.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-K2MTgtz7Jww/Wf0-4dE-dFI/AAAAAAAAXPM/UgaNr9U3wn0yXR8A-brsd2PDTaVamqHJQCLcBGAs/s1600/Private%2Bvs%2BPublic%2BJobs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1250" height="217" src="https://2.bp.blogspot.com/-K2MTgtz7Jww/Wf0-4dE-dFI/AAAAAAAAXPM/UgaNr9U3wn0yXR8A-brsd2PDTaVamqHJQCLcBGAs/s400/Private%2Bvs%2BPublic%2BJobs.jpg" width="400" /></a></div><br />As the chart above shows, public sector jobs haven't grown for a long time. This is actually good, since it means that the public sector is shrinking relative to the rest of the economy, and that acts as a tailwind to growth.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-_aLHO-0WNoo/Wf0-G3Tx9tI/AAAAAAAAXPE/hnSjTy8rMsIfyuMq0ke5bhv-jA1uirjEgCLcBGAs/s1600/Private%2BSector%2BJobs%2BGrowth.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1130" height="241" src="https://4.bp.blogspot.com/-_aLHO-0WNoo/Wf0-G3Tx9tI/AAAAAAAAXPE/hnSjTy8rMsIfyuMq0ke5bhv-jA1uirjEgCLcBGAs/s400/Private%2BSector%2BJobs%2BGrowth.jpg" width="400" /></a></div><br />As the chart above shows, the growth rate of private sector jobs has been tapering off for the past three years. The current pace, about 1.5% per year, is the slowest we have seen since the recovery got underway. By itself, this is a disappointing indicator. At the very least, it reinforces the fact that the current recovery has been weak because business investment has been weak. Companies are generating healthy profits, but they are not investing much for the future. Without a pickup in investment we are very unlikely to see any pickup in jobs growth or in productivity.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-i2kZ6Wvs8jI/Wf1BGA-XOkI/AAAAAAAAXPY/q5ldH8L4EBYsfaafvugMoKFRQWn9SDa_ACLcBGAs/s1600/Real%2BPrivate%2BInvstmt.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1088" height="250" src="https://3.bp.blogspot.com/-i2kZ6Wvs8jI/Wf1BGA-XOkI/AAAAAAAAXPY/q5ldH8L4EBYsfaafvugMoKFRQWn9SDa_ACLcBGAs/s400/Real%2BPrivate%2BInvstmt.jpg" width="400" /></a></div><br />As the chart above shows, private sector investment hasn't grown much at all for the past 10 years. This is one of the root causes of the fact that the current recovery has been the weakest ever.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-02W-WoLmNZk/Wf1CguPIpHI/AAAAAAAAXPk/39V7PF3XTXYhc9SB3QHEaEnyuY7RAJmDgCLcBGAs/s1600/NAPM%2Bvs%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="710" data-original-width="1226" height="232" src="https://2.bp.blogspot.com/-02W-WoLmNZk/Wf1CguPIpHI/AAAAAAAAXPk/39V7PF3XTXYhc9SB3QHEaEnyuY7RAJmDgCLcBGAs/s400/NAPM%2Bvs%2BGDP.jpg" width="400" /></a></div><br />The October ISM manufacturing survey declined a bit from September, but is still at very strong levels. This strongly suggests that GDP growth in the current quarter will be at least 3-4%. If so, that in turn would be a good indicator that labor productivity continues to improve.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-Aq_Hv5DF-uQ/Wf1CtUWIHiI/AAAAAAAAXPo/PMYUhwq8h90-4MStS-Cct8-l1rM2OdKVgCLcBGAs/s1600/US%2Bvs%2BEurozone%2BServ.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="680" data-original-width="1138" height="241" src="https://2.bp.blogspot.com/-Aq_Hv5DF-uQ/Wf1CtUWIHiI/AAAAAAAAXPo/PMYUhwq8h90-4MStS-Cct8-l1rM2OdKVgCLcBGAs/s400/US%2Bvs%2BEurozone%2BServ.jpg" width="400" /></a></div><br />The much larger service sector of the economy is also showing very positive readings in the October ISM survey. The Eurozone is doing well also. We are in a synchronized global upturn, and that is very good.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-_FxL0bjgKUI/Wf1C40D-JSI/AAAAAAAAXPs/NAN0A2UY9gQggaLsU9uc7sE8Lt_bFaxbQCLcBGAs/s1600/ISM%2BEmployment.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1122" height="242" src="https://1.bp.blogspot.com/-_FxL0bjgKUI/Wf1C40D-JSI/AAAAAAAAXPs/NAN0A2UY9gQggaLsU9uc7sE8Lt_bFaxbQCLcBGAs/s400/ISM%2BEmployment.jpg" width="400" /></a></div><br />The manufacturing sector must be feeling fairly optimistic, since a solid majority of those surveyed report increased hiring plans. This bodes well for future jobs growth.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://1.bp.blogspot.com/-UDg1Werd3iA/Wf1EP5w_tPI/AAAAAAAAXP4/q0T32_wAjpU2KwjKoM9tQcsBCexpzMQ3gCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://1.bp.blogspot.com/-UDg1Werd3iA/Wf1EP5w_tPI/AAAAAAAAXP4/q0T32_wAjpU2KwjKoM9tQcsBCexpzMQ3gCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><br />Real yields on 5-yr TIPS have tended to track the economy's real growth rate, as the chart above shows. Real yields have been in a modest uptrend for the past few years; I take this as a sign that the market is very reluctant to price in a strong recovery. According to the bond market, the outlook for the economy has improved only very modestly in the past year or so. No sign of exuberance here! Also, no sign of great expectations for tax reform. The market is still very cautious about the growth outlook.<br /><br />So what about Trump's tax reform proposal? It looks good, but it could be better. It's very business-friendly (e.g., cutting the corporate tax rate significantly, allowing for immediate expensing, shifting to a territorial system that taxes profits only at their source, and eliminating or limiting many deductions). But it's tainted by keeping a very high rate on top income earners (and a new, even higher rate on those who make more than a million), and by not reducing the tax on capital gains and dividend income. However, these negative effects are somewhat offset by the phaseout of the death tax, the elimination of the alternative minimum tax, and the indexation of tax brackets by future inflation.<br /><br />Trump's proposal effectively shifts a lot of the corporate tax burden to individuals, which in principle is a good thing, because in theory there should be no tax on businesses. Whatever tax businesses do pay is effectively passed on to consumers, employees, and shareholders—better and more efficient to tax them directly than indirectly. The top rate for individuals is there purely for political purposes; it will do nothing to stimulate investment or the economy because it fails to increase the incentives of the most successful to invest, take risk, and work harder. That's like hobbling those most capable of creating new jobs. It will also mean that those in the middle class who strive to reach upper class status will face a very steep marginal tax rate curve, thus creating new burdens for the middle class. And by creating very different top rates for individuals and corporations, it will result in myriad efforts to arbitrage the difference (e.g., by switching from S corp to C corp status).<br /><br />It will, however, very likely result in more investment in the US, since it sharply increases the after-tax returns to corporate risk-taking in the US relative to other countries. Lots of capital that has fled high US business tax rates will likely return, with the net result being to increase the ratio of capital to labor in the US. That in turn would have the salutary effect of boosting wage income, because when you add capital to an economy you automatically make labor relatively scarce, and that has the effect of boosting wages. (If you want to invest more in an economy, you need to hire people to run the business.) If this tax proposal passes, we can expect to see more overall growth in the economy, more jobs creation, PLUS higher real incomes for the vast middle class. Unemployment is low, so a significant increase in the demand for labor is almost certain to require higher real wages. Rising real incomes would be a very welcome thing for everyone.<br /><br />True tax reform requires the elimination of deductions and a lower and flatter tax rate structure. This proposal goes part way on the deduction front and a long way on the corporate tax front. Unfortunately, it makes the individual tax rate structure steeper and more progressive. It's a shame that Republicans couldn't propose something worth doing on all fronts without first caving to potential political opposition. But I won't let the perfect be the enemy of the good. This proposal beats the heck out of doing nothing!Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com24tag:blogger.com,1999:blog-6616959642391988608.post-22966354746330019822017-10-27T16:41:00.000-07:002017-10-27T16:41:10.723-07:00Key charts updated3rd Quarter GDP came in stronger than expected (3.0% vs 2.6%) and a bit stronger than the 2.2% growth rate of the current expansion, but the market remains unconvinced that the US economy is indeed accelerating. Tax reform may be on Congress' table, but I can detect few if any signs that the market is optimistic about it happening, or even if it happens, whether it will be a significant positive for the economic outlook. This may sound odd, to be sure, given that the stock market has been posting serial new, all-time highs since mid-2016. But consider that since its pre-recession (late 2007) peak, the S&amp;P 500 is up at an annualized rate of just over 5%—which is lower than its long-term average of just over 6% per year. The market is doing well, of course, but arguably it's not yet in "off the charts" mode.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-Hv9LpCOb9wE/WfOvTTgLXTI/AAAAAAAAXN4/ktJaGh-hlYA77KiLGwE6Ol0BMuM5akUdwCLcBGAs/s1600/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1142" height="240" src="https://3.bp.blogspot.com/-Hv9LpCOb9wE/WfOvTTgLXTI/AAAAAAAAXN4/ktJaGh-hlYA77KiLGwE6Ol0BMuM5akUdwCLcBGAs/s400/Real%2BGDP%2Bvs%2B3%2525%2Btrend.jpg" width="400" /></a></div><br />I've been posting updated versions of this spectacular chart for many years now. It shows clearly how unique the current business cycle expansion has been in the economic history of the US economy. From 1965 through 2007, the US economy grew at a trend rate of about 3.1% per year. It slipped below this trend during recessions, and exceeded the trend during boom times. But it invariably returned to trend given a few years. (Milton Friedman in 1964 wrote a paper about this, calling it the <a href="http://scottgrannis.blogspot.com/2009/06/thinking-about-gdp-growth.html">Plucking Model</a>.) The current expansion has been by far the weakest on record. Relative to its previous trend, the US economy is more than $3 trillion smaller than it might have been had things played out this time as they have before.<br /><br />What's the cause of this underperformance, especially considering that since late 2008 the Fed has massively expanded its balance sheet? My list of reasons lays the blame on two major factors: 1) an oppressive expansion of government, in the form of increased regulatory and tax burdens, and 2) a shell-shocked market that has yet to regain its former level of confidence in the wake of the worst recession since the Depression.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-WPI6DMWcL2A/WfOyVCxQsYI/AAAAAAAAXOE/JjW5etdr4-0wmcFtXJ0hMou91-fSEtmzwCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1228" height="223" src="https://4.bp.blogspot.com/-WPI6DMWcL2A/WfOyVCxQsYI/AAAAAAAAXOE/JjW5etdr4-0wmcFtXJ0hMou91-fSEtmzwCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2B2-yr%2BGDP.jpg" width="400" /></a></div><br />Thanks to TIPS (Treasury Inflation-Protected Securities), which were introduced in 1997, we have real-time knowledge of the market's expectation for risk-free, inflation-adjusted returns. (TIPS pay a real rate of interest in addition to whatever the inflation rate happens to be. The price of TIPS varies inversely with the market level of the real yield on TIPS.) As the chart above shows, the level of real yields on TIPS tends to track the economy's real growth rate, much as common sense would suggest. When economic growth was booming in the late 1990s, TIPS paid a real rate of interest of about 4%, since they had to compete with the market's expectation for 4-5% real economic growth. But with the trend rate of growth having now slowed to just over 2%, the real rate of interest on TIPS is only modestly positive: 0.2% for the next 5 years, as of today. If the market thought the US economy were on track to deliver 3%+ rates of growth in the years ahead, I'm confident that the real yield on 5-yr TIPS would be in the neighborhood of 1-2%, if not higher.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://3.bp.blogspot.com/-u5dcz2ux_vw/WfO0AyFzTBI/AAAAAAAAXOQ/Ben9BPKJ6Lc6yIDRcbHc8UwutOso7rLAACLcBGAs/s1600/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="684" data-original-width="1128" height="242" src="https://3.bp.blogspot.com/-u5dcz2ux_vw/WfO0AyFzTBI/AAAAAAAAXOQ/Ben9BPKJ6Lc6yIDRcbHc8UwutOso7rLAACLcBGAs/s400/5-yr%2Breal%2Bvs%2Breal%2BFFs.jpg" width="400" /></a></div><br />The chart above compares the real yield on 5-yr TIPS (red line) with the ex-post real yield on the Fed funds rate. This is akin to viewing two points on the real yield curve: overnight rates and 5-yr rates. In effect, the red line is the market's expectation for what the real Fed funds rate is going to average over the next 5 years. And of course, the real Fed funds rate is the rate that the Fed is actually targeting. As you can see, the market expects only a very modest amount of tightening from the Fed in the years to come; 2-3 rate nominal rate hikes over the next few years, and hardly any hike at all in real overnight rates. That makes sense only if you believe that both the market and the Fed agree that the economy has very limited upside growth potential. If the market thought the economy were set to grow at a 3%+ rate for the next several years, the market would immediately assume—and the Fed would probably agree—that there would be a series of rate hikes in the future, not just 2 or 3.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-sDmj4896VMo/WfO1aB4cPEI/AAAAAAAAXOc/pvEq3TT7Dp4Fhjvq2NEYmuRi68li1bpSgCLcBGAs/s1600/5-yr%2BTIPS%2Bvs%2BTrs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="666" data-original-width="1254" height="211" src="https://2.bp.blogspot.com/-sDmj4896VMo/WfO1aB4cPEI/AAAAAAAAXOc/pvEq3TT7Dp4Fhjvq2NEYmuRi68li1bpSgCLcBGAs/s400/5-yr%2BTIPS%2Bvs%2BTrs.jpg" width="400" /></a></div><br />The chart above compares the real and nominal yields on 5-yr Treasuries (red and blue lines) with the difference between the two (green line), which is the market's expectation of what the CPI will average over the next 5 years. With 5-yr inflation expectations today at 1.85%, the market is only a tiny bit concerned that the Fed will be unable to hit its 2% inflation target. Looking ahead, the market sees pretty much the same amount of inflation that we have seen over the past few decades. Nothing surprising. The market is thus fairly confident that the Fed is not going to do much going forward, and whatever it does, the Fed is unlikely to be too tight or too easy. You may not agree with that assessment, but that's what the market tea leaves are saying.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-F8Tf6uRs728/WfO88uF8caI/AAAAAAAAXOw/Jj-ZTrvb0tsQsSNIO-TsjL_FIvnEJw0zQCLcBGAs/s1600/Walls%2Bof%2Bworry.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="718" data-original-width="1244" height="232" src="https://4.bp.blogspot.com/-F8Tf6uRs728/WfO88uF8caI/AAAAAAAAXOw/Jj-ZTrvb0tsQsSNIO-TsjL_FIvnEJw0zQCLcBGAs/s400/Walls%2Bof%2Bworry.jpg" width="400" /></a></div><br />The chart above suggests that one reason the market is up is because the market is not very worried about whatever is going on in the world right now. The Vix index is relatively low, and 10-yr Treasury yields are near the high end of their recent range. The combination of the two (red line) suggests a lack of fear and a lack of concern that the economy could decelerate meaningfully.<br /><br />If the market is not very optimistic about the economy's ability to grow at a significantly faster pace, as the charts above strongly suggest, then it stands to reason that a failure by Trump and the Republicans to pass significant, growth-friendly tax reform would not likely result in a significant equity market selloff. But should they be successful, then the market's upside potential could be significant.<br /><br />I hasten to add, however, that a stronger economy would perforce result in an unexpected rise in real and nominal interest rates (and more rate hikes from the Fed than are currently anticipated). Higher-than-expected rates would obviously depress bond prices, and, in similar fashion, could depress the market's PE ratio (which is the inverse of the earnings yield on equities, and thus similar to a bond price), thus limiting further gains in equity prices to a rate that is somewhat less than the increase in earnings. So even if Trump and the Republicans are successful, we are probably not on the cusp of a monster equity rally. In other words, the next Wall of Worry could be higher-than-expected interest rates, which would put downward pressure on equity prices because they would imply a higher discount rate and a lower present value of future after-tax corporate profits. That downward pressure on equity prices would probably be offset—though not entirely—by rising earnings.Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com18tag:blogger.com,1999:blog-6616959642391988608.post-74668989333384400672017-10-20T14:57:00.000-07:002017-10-20T18:45:50.002-07:00Not cutting tax rates is boosting the deficitIt's pandering season again, with politicians and journalists wringing their hands about how cutting taxes will be a windfall to the rich and result in higher deficits. The truth, however, is that by NOT cutting taxes the federal government is losing money and the economy is suffering from sluggish growth. Cutting taxes would almost surely result in a significant boost in revenues and stronger growth. How do I know this? Since early last year (February 2016, to be exact), when talk of tax cuts began to spread and politicians on both sides of the aisle began to agree that our corporate tax rate—the highest in the developing world—should be cut, <i>revenues from corporate and individual income taxes have flatlined, </i>despite the fact that personal incomes have increased by almost 5%, trailing earnings per share have increased 8%, and the stock market has jumped some 30%.<br /><br />It's amazing: rising incomes, rising profits, and soaring asset prices have resulted in <i>no increase </i>in&nbsp;revenues to the federal government, even though tax rates weren't cut. How could that possibly happen? Simple: people are rational, and they respond to incentives. Given the incentive that tax rates may be reduced in the future, individuals and corporations have apparently taken steps to reduce their current tax liabilities by delaying income, accelerating deductions, postponing investments, and postponing the realization of profits.<br /><br />Consider these simple facts: S&amp;P 500 trading volume has plunged over 40% since early last year. One reason stocks are up is that people are increasingly reluctant to sell; on the margin they would rather postpone the realization of their gains in order to minimize their current income tax liability. I can assure you that has been a powerful motivator for me, and I'll wager that there are millions of investors who would agree. It's no wonder that NYSE member firms <a href="http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&amp;key=3153&amp;category=8http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&amp;key=3153&amp;category=8">report</a> a 25% increase in margin balances since Feb. '16 (from $436 billion to $551 billion) after no increase over the previous two years. Need income but don't want to pay capital gains taxes? Just don't sell anything and instead add to your margin balance.<br /><br />Here are some charts which fill out the story:<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-AMeDOLKGXcs/WepXlqniOPI/AAAAAAAAXNQ/yuwW8yMKI1YXvvA0M5UL3_S-4RpbpP5BQCLcBGAs/s1600/Receipts%2Band%2BOutlays.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="678" data-original-width="1112" height="243" src="https://4.bp.blogspot.com/-AMeDOLKGXcs/WepXlqniOPI/AAAAAAAAXNQ/yuwW8yMKI1YXvvA0M5UL3_S-4RpbpP5BQCLcBGAs/s400/Receipts%2Band%2BOutlays.jpg" width="400" /></a></div><br />The chart above shows the rolling 12-month totals of federal spending and federal revenues. Spending has been increasing steadily for the past several years, roughly in line with the growth of the economy. Revenues, however, stopped growing early last year. As a result, the 12-month deficit has increased from $405 billion in February 2016 to $665 billion in September 2017. That's a whopping increase of over 60%!<br /><div class="separator" style="clear: both; text-align: center;"><br /></div><a href="https://3.bp.blogspot.com/-nDQFisKJnxs/WepYXTcGWcI/AAAAAAAAXNc/VlzBzWrftLA5_tUxnKOCUZqB6oiO02HBQCLcBGAs/s1600/Federal%2BRevenues.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="714" data-original-width="1136" height="251" src="https://3.bp.blogspot.com/-nDQFisKJnxs/WepYXTcGWcI/AAAAAAAAXNc/VlzBzWrftLA5_tUxnKOCUZqB6oiO02HBQCLcBGAs/s400/Federal%2BRevenues.jpg" width="400" /></a><br /><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="" style="clear: both; text-align: left;">The chart above shows the major sources of federal revenues (it excludes things such as excise and customs taxes, and miscellaneous revenues, all of which are down somewhat). The only revenue category that has been increasing steadily for the past few years is Payroll Taxes (i.e., income tax withholding), by about 5% per year. That's very much in line with the growth of wages and salaries, which have been increasing at a 3.8% annual rate since Feb. '16. The thing that is unique with payroll taxes is that individuals don't have much discretion over their reported income. If their salary goes up, their withholding is going to go up as well. But individual income taxes are different. They are impacted by deductions, which can be shifted in time, as well as capital gains taxes, which can be legally postponed indefinitely, simply by not selling an appreciated asset. The rich can employ a variety of strategies to postpone or defer their income.</div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="" style="clear: both; text-align: left;">As it turns out, revenues from individual income taxes have experienced zero growth since Feb. '16, despite ongoing growth in personal income and sharply rising stock prices. Corporate income tax revenues have actually declined by about 10% since Feb. '16, despite an 8% rise in trailing, after-tax EPS over the same period. If you were the head of a large corporation and you thought there was a good chance of a meaningful cut in corporate income taxes, wouldn't you take all available steps to postpone income and accelerate deductions? Is it any wonder that US corporations have refused to repatriate trillions of overseas profits?&nbsp;</div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://2.bp.blogspot.com/-RwhccmwbzEk/WepXtra8QLI/AAAAAAAAXNU/lhkNtcDsVbQFaDP5oHRRSuX7WqTQpkIEgCLcBGAs/s1600/Federal%2BRevenue%2B%2525%2Bof%2BGDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="682" data-original-width="1102" height="250" src="https://2.bp.blogspot.com/-RwhccmwbzEk/WepXtra8QLI/AAAAAAAAXNU/lhkNtcDsVbQFaDP5oHRRSuX7WqTQpkIEgCLcBGAs/s400/Federal%2BRevenue%2B%2525%2Bof%2BGDP.jpg" width="400" /></a></div><br />So, despite ongoing growth in the economy and in incomes, plus surging stock prices, federal revenues have declined by about 1% of GDP since early last year, as the chart above shows. A static model would have projected a significant increase in revenues. No one (especially the OMB, which is still enamored of static forecasting models) expected federal revenues to be flat over the past 18-19 months. &nbsp;But that's what happened.<br /><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://4.bp.blogspot.com/-bwsXj4E3rN4/WepaM5ndrwI/AAAAAAAAXNo/W20XVv5ncq0ir_NuGXtBIEOEf1jJBovhQCLcBGAs/s1600/Budget%2Bdeficit-surplus.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="718" data-original-width="1172" height="245" src="https://4.bp.blogspot.com/-bwsXj4E3rN4/WepaM5ndrwI/AAAAAAAAXNo/W20XVv5ncq0ir_NuGXtBIEOEf1jJBovhQCLcBGAs/s400/Budget%2Bdeficit-surplus.jpg" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div class="separator" style="clear: both; text-align: left;">As the chart above shows, the rolling 12-month federal budget deficit has increased from $405 billion in &nbsp;Feb. '16 to $666 billion in Sep. '17. Relative to GDP, the federal deficit has increased from 2.4% to 3.4%. <i>And it's ALL due to zero growth in tax receipts</i>, which occurred despite no reduction in tax rates and sizable increases in incomes and capital gains.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">It's only reasonable to conclude that the reason federal revenues have failed to materialize as would have been expected is that people and corporations have taken meaningful steps to postpone income, accelerate deductions, and postpone the realization of capital gains. And they have done all that because they have been thinking there was a decent chance of significant tax reform.&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">It's a safe bet that if the tax code is reformed, and marginal tax rates on incomes, capital gains, and corporate profits are reduced, Treasury will see an almost immediate surge in revenue. Tax reform would unleash a wave of profit-taking, a surge of capital gains realizations, a massive redeployment of capital to more productive uses, more investment (reducing taxes increases the after-tax returns to investment, thus prompting more investment), more risk-taking, more work, more growth, and ultimately reduced budget deficits. I'm not talking ideology, I'm just talking basic common sense.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">But won't the rich get the bulk of the benefit from lower tax rates? Sure, because the top 10% of income earners pay about 70% of all income taxes, and half the working population pays zero income tax. Anyway, wouldn't you rather let a rich person keep more of his money, instead of giving it to the politicians in Washington? Who do you think would spend a million dollars more productively: a rich person who is already consuming as much as he or she wants, or a politician, who would love to buy votes? When the rich keep more of their hard-earned money, they almost certainly will invest most or all of it, and that's what creates jobs and prosperity. When politicians get a windfall of revenues, they will spend it, and don't forget that over 70% of every dollar that Congress spends goes out in the form of transfer payments (i.e., money given to people who haven't worked for it).&nbsp;</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">Congress needs to cut taxes in order to boost revenues and stimulate the economy. Quickly! We can't afford to wait.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">UPDATE: Art Laffer has made this same point repeatedly over the years when explaining the mistake that Reagan made in phasing in his tax cuts. If you promise that tax rates will fall in the future, you only weaken the economy today. When lower tax rates make sense, as they do today (especially corporate tax rates) rates need to be cut ASAP, otherwise capital will go dormant, awaiting the lower rates.</div>Scott Grannishttp://www.blogger.com/profile/14028519647946868684noreply@blogger.com25